Thursday, December 29, 2011

Inflation Comes in Phases

One of the most interesting things that I recently learned is that "inflation" is a process; it comes in phases. 

According to Murray N. Rothbard's book The Mystery of Banking, inflation comes in phases.  This conclusion was derived earlier by Ludwig von Mises in his study of the German hyperinflation of 1923.

If you were to take a sophomore-level macro-economics course, you would be told that money is neutral, i.e., if the money supply were to double then the price level would also double.  What is interesting about this "inflation phases" theory is that the money neutrality assumption presented in the textbooks does not hold.  In fact, in Phase I, the money supply expands much more than the price level rises.  This is because there are two conflicting forces at work:  the money supply and the behavior of expectations.  The expanding money supply will, for a given demand for money curve, cause the price level to rise, which is the same thing as saying that the purchasing power of money will fall.  However, according to the Misesian inspired theory presented by Rothbard, a second force operates against the first, namely, a change in expectations partially offsets the effects of the money supply expansion.  In particular, the model assumes that in Phase I deflationary expectations exist, i.e., people expect to see a lower price level in the near future.  This implies that people are willing to hold much larger cash balances; consequently, their demand for money increases.  A higher demand for money for any given supply of money tends to depress prices or to increase the purchasing power of money.  The reason why deflationary expectations cause people to want to hold more money is simply that people are anticipating a "bargain" in the future.  People are expecting much lower prices in the future; consequently, they want to stock up on money so that they can go on a shopping spree in the future.  Consequently, we might see a 50% increase in the money supply but only a 10% increase in prices. 

The other observation that I want to make at this point is this:  I was surprised that the Mises-Rothbard theory incorporated expectations, specifically deflationary expectations.  When I flipped through Roger Garrison's book Time and Money:  The Macroeconomics of Capital Structure, I got the impression that "expectations" were problematic for Austrian school macroeconomics.  "What about expectations" was the refrain of the critics back during the big 1930s debates, which inspired Garrison's book (the whole Keynes versus Hayek theme).  For example, Garrison writes, "But in countering Keynes's "expectations without capital theory," Hayek (our Austrian economist in the Mises-Rothbard school) produced--or so it could be argued--a "capital theory WITHOUT EXPECTATIONS."  Granted that their might be a subtle way to reconcile these two works.  And of course, I might be in error because Garrison's book is on capital structure while Rothbard's is on money and banking, so I might be trying to link two dissimilar discussions.  I am not sure; I am still learning all these theories.  I just wanted to point out a possible point of inconsistency or discrepancy.  Still, it seemed to me from Garrison's book that "expectations" was a weak spot (at least when the discussion was about Hayek's triangles and capital theory), so seeing expectations playing such a major role in the Mises-Rothbard theory was a bit shocking for me.  I am intrigued; I wonder what to make of it all.  Maybe "expectations" are not so problematic to the Austrian macroeconomic model after all since Rothbard incorporates expectations in his model by allowing for changes in expectations that then cause changes in the demand for money curve, i.e., the curve will shift either to the right or to the left because of changes in expectations. 

In conclusion, the biggest shocker for me was to learn that "inflation comes in phases."  I never knew that before.  Second, the idea that the money supply and the price level can change but in disproportionate amounts (e.g., money supply goes up 100% but prices go up only 15%) was also new to me.  Finally, I was also a bit surprised that the Mises-Rothbard model did incorporate expectations.  These are the three surprises that I have come across so far in Rothbard's "Mystery of Banking."  Since I am still reading this book, I expect to find many more interesting discoveries, which I will share.

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