Inflation vs. Zero-Sum Economics: A Question (Update: Answered!)

March 21, 2011

Comments

Can some of the more economically minded in the house explain something to me?

I was having a discussion with someone about economics in which two claims were made by the same person. The first, is that inflation is always bad, and so currency should be on some sort of standard (he preferred the gold standard). He also, at another point in the discussion, made the comment that too many people make a mistake of thinking that economics is zero-sum, quoting Milton Friedman thusly:

“Most economic fallacies derive from the neglect of this simple insight, from the tendency to assume that there is a fixed pie, that one party can gain only at the expense of another.”

This strikes me as being contradictory. Absent inflation (i.e. growth in the supply of money) then there must be a fixed pie of wealth, right? So while it’s apparent that hyper-inflation is bad (a glut of money pouring in too fast for the economy to handle), it seems to me that economic growth is absolutely predicated on some level of mild inflation.

Is that right? Or am I missing something?

Update: Thanks to the wonderful folks in the comments, I figured out what the issue was — I was hanging on to the old school definition of inflation as “increase in the money supply.” So I was trying to imagine non-zero sum economics with a finite, fixed amount of money, which just didn’t make sense to me. To those of you who refreshed me on the idea that inflation is simply a rise in general prices, which can be, but isn’t necessarily driven by increases in the money supply, thank you.

28 responses to “Inflation vs. Zero-Sum Economics: A Question (Update: Answered!)”

legion

March 21, 2011 at 1:38 pm

No, you’re right. Basically, the person you’re debating with doesn’t really grasp the concept of inflation at all.
john personna

March 21, 2011 at 1:47 pm

Two separate issues.

A tree is not firewood, mud is not a pot, that deer up on the hill is not meat. So no, there is not a fixed pie.

On inflation, most economists try to tell us that a little is good. I’m not sure I follow all their reasoning. But the part I accept might be that the Money Illusion can lead people to think growth in wages are progress, make them spend more, rinse, repeat.

That and, inflation is a tax on the inflexible, the unproductive. It rewards those who constantly pursue.

(I say this as predominantly a saver, who could use higher, real, interest rates.)
john personna

March 21, 2011 at 1:49 pm

Maybe I should give a link for the Money Illusion
Moosebreath

March 21, 2011 at 1:51 pm

I agree that a small amount of inflation (under 3% per year) is harmless, and even have seen some arguments for benefits to it (e.g., it is easier to get an employee who is performing marginally to accept a 2% raise in an era with 3% inflation than take a 1% pay cut in an era with no inflation, even though they amount to the same thing).

On the other hand, “Absent inflation (i.e. growth in the supply of money) then there must be a fixed pie of wealth, right?” seems wrong to me. There may be a fixed supply of money, but if more goods are produced, that creates more consumption and thus more wealth, even if there is no more money chasing the additional goods.
Daniel McIntosh

March 21, 2011 at 2:02 pm

If there is an increase in real wealth (more products, services, etc.) and the supply of money remains constant, then we should expect deflation–fewer dollars buying more of a product.

All other things being equal, course.

P.S. Even the overall supply of gold increases over time.
Andyman

March 21, 2011 at 2:07 pm

I have a hard time believing that inflation is always a bad thing, and an even harder time believing that inflation is always a bad thing for everyone, or for even most people, or for even enough sufficiently important people that it would be a worthwhile policy goal.

Yglesias had a great line about appeasing the shoebox savings crowd to that effect earlier today.

My understanding is that wealth creation implies inflation only to the extent that your relatively illiquid assets can be monetized. For example, imagine that an alien mothership comes to earth and bestows each and every one of us with a bottomless beer mug. We’re all quite a bit wealthier from a standard-of-living perspective but we’re not any wealthier from a monetary perspective because it’s hard to imagine a market for an inexhaustible resource which everyone already possesses. So the inflationary effect, on first order, might be negligible.
Dave Schuler

March 21, 2011 at 2:43 pm

Okay, Alex, I’ll give it a stab. Your definition of inflation is wrong. Inflation is an increase in the general level of prices of goods and services. As jp implies above even with a fixed money supply the general level of prices may rise or fall. It depends on the goods and services brought to market.

Also, even in a non-fiat currency the money supply can increase without it being inflationary. The supply can increase via lending and if the lending results in an increase in the total goods and services it is not necessarily inflationary.
Dave Schuler

March 21, 2011 at 2:56 pm

While I’m on the subject your definition of hyperinflation is wrong, too. Hyperinflation is a general increase in the prices of goods and services at a rate so as to approximate or exceed 100% over a period of three years. That’s about 25% a year accompanied by a vicious cycle.
EJ

March 21, 2011 at 3:03 pm

you are talking about two different issues.

The ideal would be to have no inflation, but the problem is this is tough to hit so most eocnomists hold the position that a mild amount of inflation is better than a mild amount of deflation. Deflation can create a negative spiral where you hold off purchase and investment decisions in waiting for nominal prices to fall which in turn cause more price depressiationa nd you end up in a recession.

Inflation is generally bad for a few reasons.

1. it erodes savings. Unless your wealth is in something that rised with inlfation (TIPS, commodities) it takes the value from people

2. higher inflation tends to be mroe vaoltile which causes inrcreases risk to occur in making long term eocnomic decisions. This is one of the reaosn why real interest rates tend to be higher in high inflationary periods – to accounf for this risk. So high inflation can also help cause lower total output.

3. Inflation does not hit everyone at one time. I forget the name of this, but is called the ____ cycle, where inflation hurts those the leats who use the money the earliest in money cycle. So lenders originally get a windfall of cheaper money, then the extra money drives up commodites and real asset prices and then onyl after that do naminal wages go up. So those releying most on labor wages get hit by inflation the most.

4. It can creat an uncontrollable spiral. If inflationary expectations increase, this increase wage and good price dmeand which in turn cause prices to rise further.

5. Capital gains and itnerest taxes are not adjusted for inflation. So high inflation destroys the stoc market and interest payments. The inflation adjusted tax rate rises as inflation rises. Int he late 70’s the effective average real captial gains tax rate was about 100%.

The rate of inflation has effects on growth rates and people’s wealth. It is not at allr elated to size of the pie not being fixed. These are two different issues. Perhaps I’m just not understanidng what you are saying alex, but I dont get how these two things are related or contadictory.
EJ

March 21, 2011 at 3:04 pm

at any given point there is a fixed pie. Over time the pie’s size changes.
Alex Knapp

March 21, 2011 at 3:05 pm

Uh… hang on folks. There’s apparently an issue of definitions here. Isn’t inflation defined as an increase in the supply of money?
EJ

March 21, 2011 at 3:11 pm

or maybe im getting what you are saying now. That wealth can onyl grow with inflation?

I think you are missing what iflation is. Inflation is not the increase in the money supply. Rather, itis the general increase in the price level of goods and services, which happens when money supply growth expands in excess of demand for money, which is correlated to total real output of the eocnomy.

Through the gold standard years, over the long run, the money supply grew roughly in proportion to economic output so that a dollar was worth the same in 1913 as it was in 1790. If the amount of money remained fixed, they you would have deflation. But in theory you could strill have economic growth, its just that the value of each dollar would go up. You could buy 2 apples with a dollar rather than 1.

Nominal changes in monetary value is not the same thing as real output changes.
EJ

March 21, 2011 at 3:13 pm

alex… this is the relationship between money supply changes and inflation. They are not the same thing.

http://en.wikipedia.org/wiki/Quantity_theory_of_money
Alex Knapp

March 21, 2011 at 3:57 pm

@EJ,

From what you’re providing, it still appears that the primary driver of inflation is still increases in the money supply, even if the definition has been broadened from the original definition.
EJ

March 21, 2011 at 4:13 pm

yes inflation is a monetary phenomena – but its not the same thing. Inflation occurs when money supply growth exceded money demand growth. Under the gold standard, the money supply did grow, it just grew int he long run at the same pace as demand growth. So from 1790 to 1913, there was virtually no inflation in net, yet there was a lot of aggrgate growth (the pie increasing size).

I guess the point here is that changes in the size of the pie over time are not dependent on any given level of inflation. The pieces of paper int he system is not what makes people wealthy. Its the total amount of real output that does. The pieces of paper only represent real output for the purpose of exchange and how much output each piece of paper represents depends on how many pieces there are. Thats where you get inflation.
EJ

March 21, 2011 at 4:15 pm

or rather how many pieces of paper there are relative to the amount of real goods
EJ

March 21, 2011 at 4:23 pm

in short, saying the economy is not a zero sum game and saying there should ideally be little or no inflation is not a contradiction
john personna

March 21, 2011 at 5:08 pm

One can either say inflation is often (the result of) an increase in money supply, or say inflation is defined as price increases resulting from an increase in money supply.
john personna

March 21, 2011 at 5:10 pm

(you have to be aware of the definition used, or implied, in context)
Taiko Drum

March 21, 2011 at 5:14 pm

“One can either say inflation is often (the result of) an increase in money supply, or say inflation is defined as price increases resulting from an increase in money supply.”

What happened to velocity of money? You can expand the money supply all you want but if nobody is spending (IOW no demand increase), there will be no pressure for price increases.
john personna

March 21, 2011 at 5:26 pm

“What happened to velocity of money?”

You can get fancy if you want 😉

What I was really speaking to is the way we just measure a change in prices of goods (a CPI basket) and call that inflation. At odds with that are the sticklers who have a formal definition for the same thing.

It is most useful to me to think of inflation as my own moderate term (1-2 years?) exposure to price increases. CPI changes are only a rude approximation of that. My bundle of goods is unique. And whether my personal exposure depends on supply or velocity … we are getting out close to “angels on a pin” territory.
john personna

March 21, 2011 at 5:27 pm

BTW, consumers can restructure their exposure. It’s one of the main reasons I drive a Prius.
Drew

March 21, 2011 at 5:37 pm

“Uh… hang on folks. There’s apparently an issue of definitions here. Isn’t inflation defined as an increase in the supply of money?”

Uh, er, well,………….no. Its an increase in the overall price level. For causation:

Alex – I know you are a biochem and lawyer, [and haven’t had the benefit of the Great University of Chicago economics staff 😉 ] but just Google “quantity theory” and get back to us. Its not rocket science. Focus on the basic equation: quantity of money, velocity, price and output. The arguments are really over stability of velocity and the output boundary.
Drew

March 21, 2011 at 5:46 pm

Alex –

Dave has picked a definition of hyperinflation – and I’d certainly say that’s hyper. Go over to GE and see my somewhat snarky comment on what “hyperinflation” really is.

I see “velocity” has also hit the radar screen. Classically, in a low interest rate environment the view is that velocity can slow down since the cost of holding cash falls “asymptotically toward zero.” Heh. Like that?? Its called a liquidity trap.

Of course if you are a bank repairing your balance sheet you can suck up that money and the economy wil have low velocity. Read: right now.

But what if velocity picks up? And it always has in the past……
Dave Schuler

March 21, 2011 at 6:05 pm

I didn’t just pull it out of a hat. It’s the one used by the International Acocunting Standards Board.
Steve Verdon

March 21, 2011 at 7:32 pm

This strikes me as being contradictory. Absent inflation (i.e. growth in the supply of money) then there must be a fixed pie of wealth, right?

Yes, at any given point in time this is true. Over time it is not.

Uh… hang on folks. There’s apparently an issue of definitions here. Isn’t inflation defined as an increase in the supply of money?

That is one definition. Another is simply a rise in the general price level. Changes in the supply of money can be referred to as monetary inflation. And in the long run changes in the money supply are the most (and perhaps the only) driver of inflation.

From what you’re providing, it still appears that the primary driver of inflation is still increases in the money supply, even if the definition has been broadened from the original definition.

Yes, increases in the money supply over and above the demand for goods and services. Looking at the QMT link that EJ provided you can see the following:

M*V = P*Q

If Q increases then M can increase without P increasing. If M increases faster than Q then something else has to change, either V or P. If V is relative fixed then the change will have to occur in P. Also, if Q and V are changing at about the same rates then increases in the money supply will increase P.

That is, you can have the money supply growing over time without any inflation. Obtaining such outcomes as a matter of policy, as EJ has noted is extraordinarily difficult.
Drew

March 21, 2011 at 9:20 pm

Dave –

I don’t know if that last comment was directed at me. In any event – you know me – I couldn’t care less what the IASB says. I generally keep my own counsel. My worldview is “what level of inflation creates real and observable changes the Average Joe has to deal with?” 25%/yr would certainly meet that standard. In fact, I’d be in the 10% range. Now, is that “inflation,” or “hyperinflation?” Sing along…….you say potayto, I say patahto……………

I’m glad to see Steve V has entered the fray. Note his disection of the variables.
Drew

March 22, 2011 at 1:56 pm

You’re welcome. Now get rid of the gd cigar……