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Author Topic: Hey!!: Understating Inflation and monetary policy
thwap
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posted 25 January 2005 07:48 AM      Profile for thwap        Edit/Delete Post  Reply With Quote 
Hey O.C.,

Very quickly: It's my belief that you're an honest guy. I wonder if you could give me some feedback on my response to something you raised.
In the thread "Making Indian Girls Cry II" you said the following:

[QUOTE] And yet another part could simply a data issue: CPI inflation generally overestimates the true rate of increase in the cost of living, especially when new products are being introduced. The most often cited number is an overestimate of 0.5% a year, so it could well be that real wages have increased by %15 since 1973. [QUOTE]

I'd just like to know if, given this possibility, you think the Bank of Canada might want to ease-up on its monetary policies.

It just seems a little perverse to have put workers [well, everybody actually] through the wringer for those two monetarist recessions, and to then say the problem might have been overstated when people complain about stagnant wages.

[ 25 January 2005: Message edited by: thwap ]


From: Hamilton | Registered: Feb 2004  |  IP: Logged
Michelle
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posted 25 January 2005 08:33 AM      Profile for Michelle   Author's Homepage     Send New Private Message      Edit/Delete Post  Reply With Quote 
It's not cool to start threads with babblers' names in them.
From: I've got a fever, and the only prescription is more cowbell. | Registered: May 2001  |  IP: Logged
Stephen Gordon
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posted 25 January 2005 08:50 AM      Profile for Stephen Gordon        Edit/Delete Post  Reply With Quote 
No harm, no foul.

That systematic overestimation is well-known; we teach it in second-year micro. And when we can do better, we do - the GDP numbers now use a 'chain-weighted' price index (the 'representative basket is updated every quarter), which is a an improvement. But since the CPI basket is updated only every five years or so, it's particularly vulnerable to that bias.

It's largely because of that systematic overestimation that the Bank of Canada's inflation target isn't any lower - the policy goal was price stability, that is, zero inflation. But since they know that CPI inflation is overestimated, the inflation target was set above zero.

I'll stop here for now - I'll get back later to discuss why the Bank thought it was a good idea in the first place.

[ 25 January 2005: Message edited by: Oliver Cromwell ]


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thwap
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posted 25 January 2005 08:50 AM      Profile for thwap        Edit/Delete Post  Reply With Quote 
Point taken.
From: Hamilton | Registered: Feb 2004  |  IP: Logged
Stephen Gordon
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posted 25 January 2005 02:11 PM      Profile for Stephen Gordon        Edit/Delete Post  Reply With Quote 
Okay, I’m back; I had to take the car to the garage.

This is not the first time you’ve asked about monetary policy, but I’ve tried to avoid the subject, mainly because the story of the last 40 years of monetary policy is a long and complicated one. Theories came and went, but AFAICT, a consensus was reached by the late 80’s, and the Bank’s current policy is consistent with that consensus. Monetary policy has gone from being the white-hot topic of my grad school days to being somewhat of a backwater. These days, it’s international macro that’s far more interesting.

Anyway, let this be the thread where we hash out monetary policy. I thought of writing up a summary, but as I was thinking it over at the garage, I realised that my summary would run to about 10,000 words, plus quite a few graphs and tables. Instead, here’s a brief(er) list of talking points, arranged in chronological order.

Pre-1965: The Phillips curve
The inverse relationship between employment and inflation was first identified as an empirical regularity, and it remained remarkable stable over the 50's and 60's. Macroeconomic policy was viewed as essentially choosing a particular point on the Phillips curve. In retrospect, what’s most astonishing is that almost no effort was spent trying to figure out why that relationship was so stable, or even why we expect that relationship to be negative.

Late 1960’s: Friedman-Phelps
They developed a theoretical model which predicted an inverse relationship between unanticipated inflation and unemployment. Wages are negotiated in advance, based on certain expectations of inflation. If prices rise more than wages, then the real wage goes down, and so does unemployment. If wages rise faster than prices, real wages go up, and firms react by cutting employment. Once people realise their mistakes, wages get re-adjusted and unemployment goes back to its ‘natural rate’ (the NAIRU). The relationship between observed inflation and unemployment would be stable only if expectations were stable.

Late 1960s/Early 1970: Monetary expansion.
Partly in order to pay for the costs of Vietnam, the US decided to inflate instead of raising taxes. It looked like a win-win proposition – seigniorage pays for Vietnam, and if inflation reduced unemployment, what harm could that do?

Early 70’s: Freidman-Phelps were right.
I know that Milton Friedman is a bit of a hate-figure here, and he’s said many things to which I take great exception. But he remains one of the few economists who have made a prediction about an important policy issue based only on theory, and in the teeth of all available evidence, and to have been proven right. Inflation rose, and unemployment stayed where it was.

Mid 70’s: Stagflation.
After the oil shock, monetary policy was loosened even more, and again, even though inflation went up, unemployment still kept going up.

Mid 70’s: Rational Expectations and Policy Irrelevance.
Most prominent theorist here is Robert Lucas, but he was joined by many others, especially the team of Sargent-Wallace. If only unexpected inflation has real effects, then everything depends on how expectations are formed in the first place. If the monetary authority announces that it’s going to increase inflation in order to fight unemployment, everyone will revise their expectations. When the policy is carried out, there’s no unexpected change in inflation, so there’s no effect on policy. Only monetary ‘surprises’ have real effects. Systematic and predictable policies have no effect.

Late 70’s/Early 80’s: Rational expectations put to the test.
Well, if an announced increase in inflation won’t reduce unemployment, that means an announced decrease in inflation won’t increase unemployment, right? Unfortunately, no. It led to the worst recession since the Great Depression. It also turned out that monetary targeting is a poor policy instrument; the once-strong link between inflation and growth in M1 disappeared as soon as it was made the fulcrum of monetary policy. Back to the drawing board.

Mid 80’s: Credibility and time consistency.
The major players here are Kydland-Prescott, who just received the Nobel for that and other things (notably creating new analytical tools for studying macroeconomics). Politicians have an incentive to persuade people to reduce their expectations of inflation. But once those expectations are lowered, they have no incentive to actually carry out a deflationary policy. If an election’s around the corner, there’s little reason to resist the temptation to cheat and create a temporary boost in employment. Announcing an anti-inflation policy isn’t enough. The policy has to be credible.

Late 80’s/Early 90s’: One more time.
In Canada, new inflation targets are announced simultaneously by the Bank and by the Finance minister (who is responsible for the Bank). Instead of targeting monetary aggregates, they’d focus on inflation directly. The US does more or less the same thing. This time, they knew better than to expect no effect on unemployment, and they were right. After the 1993 election, Crow is replaced for having pissed off too many Liberals, but Theissen maintains his predecessors’ policies. Greenspan keeps his job and becomes God.

Mid 90’s-present: Low and stable inflation.

Man, that’s long. And I now see I missed several points, such as
- What are the costs of inflation? Was the sacrifice worth it?
- How inflation complicated deficit reduction.
- Many other points that escape me for now, but which someone will surely bring up.


From: . | Registered: Oct 2003  |  IP: Logged
thwap
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posted 25 January 2005 02:26 PM      Profile for thwap        Edit/Delete Post  Reply With Quote 
O.C.

Thanks for the summary. There are some names and etc., that are new to me.

I take issue with this:

quote:
Late 70’s/Early 80’s: Rational expectations put to the test.
Well, if an announced increase in inflation won’t reduce unemployment, that means an announced decrease in inflation won’t increase unemployment, right? Unfortunately, no. It led to the worst recession since the Great Depression.

It's my belief that a significant rise in unemployment was intended by Friedman and others. Indeed, the unemployment and it's counter-effects are what are supposed to bring inflation down.
I think that there are differences between Friedman's quantity theory of money and other proponents of dear money, but the practical results are all about the same. High interest rates, economic dislocation, high unemployment, and eventually lower inflation.


From: Hamilton | Registered: Feb 2004  |  IP: Logged
Stephen Gordon
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posted 25 January 2005 02:34 PM      Profile for Stephen Gordon        Edit/Delete Post  Reply With Quote 
Possibly a bit of hyperbole there; I don't think anyone really expected disinflation to be literally costless. But the depth of the recession was definitely a surprise, and it led to the re-examination of how expectations are formed and how policies can be made to be credible and/or time-consistent. It even made it into the Meech Lake talks - at one point, the Bank asked to be made independent from the govt, like the German central bank, so that politicians wouldn't have the power to engineer electorally-driven policy surprises.
From: . | Registered: Oct 2003  |  IP: Logged
thwap
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posted 25 January 2005 04:59 PM      Profile for thwap        Edit/Delete Post  Reply With Quote 
Well, mayhap the truth lies between my hyperbole and your understatement of the authorities' intentions at the time:

quote:
an announced decrease in inflation won’t increase unemployment, right?

Which makes one think that maybe they ...

quote:
expected disinflation to be literally costless.


I'd been struck by the political uses of economics. On the one hand, seniors on fixed incomes were (as Linda McQuaig put it) the "baby seals" of the anti-inflation people. The way their pensions could be eroded by inflation was one of the big reasons that we had to wrestle inflation to the ground.

Later, when it came to keeping pensions low, (or to keep minimum wages low] policy-makers turned to the possibility that we're over-stating the inflation rate.

In the US, Tom Tomorrow lampooned this sort of behaviour, I think he had Newt Gringrich say of American seniors: "They're lucky we don't ask them for a refund!"


From: Hamilton | Registered: Feb 2004  |  IP: Logged
Stephen Gordon
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posted 25 January 2005 05:15 PM      Profile for Stephen Gordon        Edit/Delete Post  Reply With Quote 
Actually, I was referring to my hyperbole. The analysis going into the early 80's experiment was a bit more sophosticated than that, but it made use of the same logic.

We never really talked about the 'fixed-income-pensioner' case, since the answer to that problem was obvious: index the damn pensions.

The most-cited costs were those associated with uncertainty. Uncertainty about just how much real buying power a bond will generate when it comes due is a bad thing, and we'd like to avoid it. High and stable inflation we could probably live with. The problem was that high inflation was also highly unstable.

In Canada, another big cost was trying to fix the deficit while paying %15 interest rates. If we still had inflation and interest rates at the levels of the 1980's, the federal govt would still be deep in deficit.


From: . | Registered: Oct 2003  |  IP: Logged
Mandos
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posted 25 January 2005 05:33 PM      Profile for Mandos   Author's Homepage     Send New Private Message      Edit/Delete Post  Reply With Quote 
I know that there are countries that seem to manage decent growth rates with ridiculously high inflation. Turkey, for instance. Still kinda developingy, but I don't think they're a basket case. Are they?

edited to change insurance to inflation. Was reading DeLong and had insurance on my mind.

[ 25 January 2005: Message edited by: Mandos ]


From: There, there. | Registered: Jun 2001  |  IP: Logged
thwap
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posted 25 January 2005 05:37 PM      Profile for thwap        Edit/Delete Post  Reply With Quote 
quote:
Actually, I was referring to my hyperbole.

Okay. My mistake. You exaggerated their moderateness.

[edited to add: 'Hyperbolic Understatement' -- that's what i was going for.]

And yeah, McQuaig mentioned that indexing the pensions was the obvious answer to the problem. Some commentators didn't want to acknowledge that at the time though.

[ 25 January 2005: Message edited by: thwap ]


From: Hamilton | Registered: Feb 2004  |  IP: Logged
The Other Todd
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posted 25 January 2005 08:03 PM      Profile for The Other Todd     Send New Private Message      Edit/Delete Post  Reply With Quote 
For a truly wonderful examination of the politics and economics behind the 70s, the inflation spike, and the subsequent shift to sado-monatarism and afterwards, these two books are great:

After the New Economy by Doug Henwood

http://www.amazon.com/exec/obidos/tg/detail/-/1565847709/102-9363545-0466532?v=glance[/UR L]

Boob Jubilee (the essay "Us Against Them in the Me Decade" by Christian Parenti) edited by Tom Frank

[URL=http://www.amazon.com/exec/obidos/tg/detail/-/0393324303/qid=1086314027/sr=1-1/ref=sr_1_1/102-9363545-0466532?v=glance&s=books]http://www.amazon.com/exec/obidos/tg/detail/-/03 93324303/qid=1086314027/sr=1-1/ref=sr_1_1/102-9363545-0466532?v=glance&s=books

[ 25 January 2005: Message edited by: The Other Todd ]


From: Ottawa | Registered: Jan 2005  |  IP: Logged
Stephen Gordon
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posted 28 January 2005 07:37 PM      Profile for Stephen Gordon        Edit/Delete Post  Reply With Quote 
Heeheeheee

quote:
After stating his general disdain for the "dismal science," Henwood cobbles together data from all specializations of economics to support his thesis. His analysis, not bound by the restrictions of economic theory ...

Yep. That's just what the world needs: yet another tome in which the author presents his unexamined opinions - and in the process, pretending that any previous attempts to analyse his topic in anything resembling a coherent manner simply don't exist - supplemented by cherry-picked factoids. I'm putting on that on my 'must read' list - right under the Paris Hilton autobiography.


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Fidel
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posted 28 January 2005 09:54 PM      Profile for Fidel     Send New Private Message      Edit/Delete Post  Reply With Quote 
So Oliver, what's the deal with zero inflation policy today ?.

Aren't there economists who believe that zero-I is an unattainable thing that kills the economy if pursued for too long ?. I think it was Robert Solow? who showed that as the economy slows when less money flows, fewer consumers buy things like cars etc. Solow gave an example whereby as companies like GM and Ford sell fewer cars, they find other ways to realize previous profit margins, like raising the price of cars for one.

And how will the big three react to Chinese car imports next year, and will we be able to buy some cheapy cars as a result of these low wage zones like China ?.

[ 28 January 2005: Message edited by: Fidel ]


From: Viva La Revolución | Registered: Apr 2004  |  IP: Logged
Stephen Gordon
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posted 28 January 2005 10:33 PM      Profile for Stephen Gordon        Edit/Delete Post  Reply With Quote 
It's not the level of inflation that affects employment and output, it's the changes in inflation. If we moved to a higher rate of inflation, we would get a temporary boost above trend during the transition, but once we reached the new level, employment and output would go back down to trend, and all that we'd be left with would be higher inflation.

The same thing works in reverse, of course: the Great Deflation of the early 1990's is not something we'd want to go through again. But once we reached the new (lower) level of inflation, employment and output came back up to trend. (Really!)

I had a bit of a brain fart in my earlier post about the effects of variable inflation; I wanted to make the point about interest rates, and so I mentioned the effect of higher uncertainty on interest rates. But the much more important point is that we much prefer smooth, predictable income and consumption paths to ones that are subject to unpredictable cycles of boom and bust. The problem with activist monetary policy as it was practiced in the 1970's (and to certain extent during the 1980's) was that it had become a cause of macroeconomic instability instead of a remedy.

Trade has actually made things much easier for us. If we didn't have cheaper imports keeping prices down, the Bank would have had to raise interest rates in order to keep things at an even keel. As it is, we've been able to sustain impressive rates of growth of output and employment over the past 10 years, along with low inflation and low interest rates.


From: . | Registered: Oct 2003  |  IP: Logged
Fidel
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posted 28 January 2005 11:36 PM      Profile for Fidel     Send New Private Message      Edit/Delete Post  Reply With Quote 
quote:
Originally posted by Oliver Cromwell:

Trade has actually made things much easier for us. If we didn't have cheaper imports keeping prices down, the Bank would have had to raise interest rates in order to keep things at an even keel. As it is, we've been able to sustain impressive rates of growth of output and employment over the past 10 years, along with low inflation and low interest rates.

Compared to which period, OC ?. According to a StatsCan graph entitled GDP growth, annual percent Change displaying in another browser here, 1990's Canada did not realize near the same growth rates as the 1950's,60's, 70's or even the 1980's. Our economic performance under Mulroney and Chretien as measured by growth in GDP has been, at best, dismal ?.


From: Viva La Revolución | Registered: Apr 2004  |  IP: Logged
The Other Todd
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posted 29 January 2005 05:35 PM      Profile for The Other Todd     Send New Private Message      Edit/Delete Post  Reply With Quote 
quote:
Originally posted by Oliver Cromwell:
Yep. That's just what the world needs: yet another tome in which the author presents his unexamined opinions - and in the process, pretending that any previous attempts to analyse his topic in anything resembling a coherent manner simply don't exist - supplemented by cherry-picked factoids. I'm putting on that on my 'must read' list - right under the Paris Hilton autobiography.

Sorry, but his opinions are anything but unexamined.

This:

quote:
not bound by the restrictions of economic theory and its complex interplay with demographics and history

is very funny. As if bourgeois economists have the last say on what is and isn't economic theory . . . .


From: Ottawa | Registered: Jan 2005  |  IP: Logged
Stephen Gordon
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posted 29 January 2005 06:21 PM      Profile for Stephen Gordon        Edit/Delete Post  Reply With Quote 
DINGDINGDING

[duck drops from top of screen, holding a placard reading 'bourgeois']

"You just said the magic woid, thereby guaranteeing that nothing you said in that post will be taken seriously!"

Ya wanna try again?

[edited to add:]

Upon reflection, that was perhaps a tad harsh - but my reaction to being called a 'bourgeois economist' is to laugh in disbelief.

Unless you were being ironic, in which case: Good one!

[ 30 January 2005: Message edited by: Oliver Cromwell ]


From: . | Registered: Oct 2003  |  IP: Logged
Stephen Gordon
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posted 29 January 2005 09:06 PM      Profile for Stephen Gordon        Edit/Delete Post  Reply With Quote 
quote:
Originally posted by Fidel:

Compared to which period, OC ?. According to a StatsCan graph entitled GDP growth, annual percent Change displaying in another browser here, 1990's Canada did not realize near the same growth rates as the 1950's,60's, 70's or even the 1980's. Our economic performance under Mulroney and Chretien as measured by growth in GDP has been, at best, dismal ?.


Yeah, I guess 'decent' would have been a better adjective than 'impressive'; my point of reference was the 70's and the 80's, where things were really stinky.

That said, economic performance can't always be attributed to the party in power. For example, the Chretien Liberals would have had a much more difficult time of it if inflation and interest rates were still high, and if Mulroney hadn't already put the primary balance in surplus.


From: . | Registered: Oct 2003  |  IP: Logged
The Other Todd
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posted 01 February 2005 02:34 PM      Profile for The Other Todd     Send New Private Message      Edit/Delete Post  Reply With Quote 
quote:
Originally posted by Oliver Cromwell:
DINGDINGDING

[duck drops from top of screen, holding a placard reading 'bourgeois']

"You just said the magic woid, thereby guaranteeing that nothing you said in that post will be taken seriously!"

Ya wanna try again?

[edited to add:]

Upon reflection, that was perhaps a tad harsh - but my reaction to being called a 'bourgeois economist' is to laugh in disbelief.

Unless you were being ironic, in which case: Good one!

[ 30 January 2005: Message edited by: Oliver Cromwell ]


I'm sorry, but where did I call you a bourgeois economist?

And why do you object to that?


From: Ottawa | Registered: Jan 2005  |  IP: Logged
thwap
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posted 01 February 2005 03:24 PM      Profile for thwap        Edit/Delete Post  Reply With Quote 
I really value your input O.C.

You've got a tough row to hoe here.
We're all set on believing that jobs are less secure, the labour market is becoming polarized between involuntary part-time and temporary work and involuntary overtime work, that wages are stagnant, that the distribution of wealth is becoming more unequal, that homelessness is increasing, that the wealthy are making out like bandits, that corporations are forcing us all on a race to the bottom, etc.,

And then you show up with factoids and online reports that tell us it's all a mirage.

I have a hard time swallowing that, but you've at least got your ducks in a row.
For that, you serve as an excellent foil.


From: Hamilton | Registered: Feb 2004  |  IP: Logged
Stephen Gordon
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posted 01 February 2005 04:01 PM      Profile for Stephen Gordon        Edit/Delete Post  Reply With Quote 
A lot of what you say is probably true - but I don't think monetary policy is the culprit here. There are lots of things that are keeping wages low - demographic pressures, productivity issues, missing or mismatched skills, what have you. And I certainly agree that labour market uncertainty is something we can and should deal with - but I would argue that monetary policy is the wrong policy instrument.
From: . | Registered: Oct 2003  |  IP: Logged
dnuttall
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posted 01 February 2005 05:30 PM      Profile for dnuttall     Send New Private Message      Edit/Delete Post  Reply With Quote 
O.C.:

What happens to inflation and interest rates as consumption is forced to drop by resource exhaustion? I've tried to work this out, and all I get is uncertainty increases, which should drive up interest rates. But I think that's over simplified.

Take, for instance, a decrease in consumption of about 1% per year on a world wide basis caused by resource exhaustion. What will that do to interest and inflation?


From: Kanata | Registered: Mar 2004  |  IP: Logged

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