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More On Quantitative Easing, The Ben Ber-nank, And Why Deflation Is Worth Worrying About…

November 22nd, 2010 · 13 Comments
Behavioral Econ · Macroeconomics · Policy

I am beginning to understand how reading the newspaper can cause people to have a chicken-little complex about most things having to do with economics: we’re told that inflation is bad, then we’re told that lack of inflation is bad. What gives? Maybe some cartoon friends can help…I’m not sure I support the tone of this video, but the “Ben Ber-nank” part cracks me up every time for some reason. (Pay particular attention to the part about deflation- there will be a quiz at the end.)

Regarding deflation, the critter on the right says “Isn’t it good? Doesn’t it mean that people can buy more of the stuff?” and the critter on the left answers in the affirmative. The problem is that the left critter isn’t exactly right, despite the fact that it is intuitively appealing to think that if inflation is bad then deflation is good. To see this, put yourself in the shoes of a business owner rather than of a consumer for a second. Deflation refers to a decrease in the overall price level, which obviously does make “the stuff” cheaper. This means that more people will *want* to buy your stuff…but are you going to want to sell more of it? (Recall that, in markets, it takes two to tango.) Imagine I said to you “Hey, guess what? You know that stuff that you used to sell for $5? Now you can only get $4 for it because prices have dropped.” Would you want to direct as many resources to producing this stuff as you did before?

Technically, it depends. You would want to know whether the cost of the stuff that you use to make your stuff went down by as much as your price went down. If all of your costs went down by 25 percent, then the decrease in the price of your output isn’t likely to change your production decisions. Keep in mind, however, that inflation in the U.S, is measured by the “consumer price index,” which tracks the overall price level of stuff that households typically buy. (Note that deflation doesn’t have to mean that the prices on all items go down, just that the price decreases outweigh the price increases. The observation potentially explains the critters’ objection to the claim of falling prices.) Therefore, it doesn’t have to be the case that the prices on what companies buy and use change by the same amount as the prices on what consumers buy. If the price that a company can get for its stuff decreases but it’s costs don’t decrease as much, it’s going to cut back production.

This concept can be shown most clearly by taking labor costs as an example. As an employee, how pissed off would you be if your employer said “Hey, we noticed that the consumer price index is falling, so the stuff that you buy is getting cheaper. As a result, we’re going to be cutting your wages by the amount of the price drop”? Technically, the change wouldn’t make you worse off, but people tend to be very attached to their dollars:

(Source: Daniel Kahneman, Jack L. Knetsch and Richard H. Thaler, “Fairness as a Constraint on Profit Seeking: Entitlements in the Market”)

This suggests that employers are in a bit of a bind when prices go down, since they likely can’t adjust wages downward to match in order to compensate without risking projectile rotten tomatoes, rioting, etc. from their employees. Since costs don’t completely adjust to match the new price level, the firms cut back production. If firms cut back production, people get put out of work. Putting this all together, we see that deflation can actually be counterproductive in battling a recession.

Classical economists don’t worry about this too much, since they contend that all prices and costs adjust in response to price changes in order to bring the economy back to its “normal” level of output. Unfortunately, they come to this conclusion by glossing over certain aspects of human nature such as the one noted above. So where does this leave us? Can some inflation actually be a good thing?

To a degree, the answer to that question depends on who you are. Personally, I have a lot of fixed-rate debt (read, a mortgage) compared to savings, so inflation could actually make me better off, especially if inflation means that I can raise my prices and therefore my effective wage. If I were an employer, I might also welcome some inflation if it meant that I could raise the price of my output before I had to give in and adjust my employees’ wages for cost of living changes. This would (temporarily) increase my profits and give me an incentive to increase production. (This is how “the Ben Ber-nank” can say that inflation creates jobs.) If I were the Fed, I might welcome some inflation since it could encourage employers to invest and produce more in the short run, both because the real cost of borrowing would be lower (for the same reason that mortgage-heavy me is fine with inflation) and because the price of “the stuff” would go up. If I were a senior citizen (or trust fund baby) living on a fixed income, I would probably hate inflation unless I had invested in inflation-indexed securities. (Note to self: invest in some inflation-adjusted securities.) If I were a generally risk-averse person, I would dislike inflation in general because I value stability…but then I would hate deflation as well.

In summary, inflation is a lot like alcohol…in moderation, it’s not a huge deal, but it becomes very problematic if it gets out of control.

In case you were curious as to the validity of the “economists are against quantitative easing” point, the evidence for that claim is mixed. For example, some economists/journalists/businesspeople/etc. wrote an open letter to “the Ben Ber-nank” expressing their disapproval of his policies. Other economists think it’s less of a big deal. Some are even remarkably neutral and even use Scrooge McDuck to explain what is going on. As such, I kindly request that the video critters stop putting words in economists’ mouths.

(Sidenote re the video, in case it wasn’t obvious: buying Treasury bonds from the Treasury wouldn’t have the desired effect on the money supply since it wouldn’t put any money in the hands of the public, so it’s not really a relevant option to be discussing.)

Tags: Behavioral Econ · Macroeconomics · Policy

13 responses so far ↓

  • 1 Russ Nelson // Nov 22, 2010 at 8:54 pm

    Not impressed by that reasoning. Consider that the price of consumer electronics drops all the time, but you can buy it from many different retail locations. If your reasoning was correct, nobody would want to sell consumer electronics.

    Markets, when regulated by customers, come up with solutions to the problem of selling things to customers. Markets, when regulated by politicians, come up with solutions to keep politicians happy. Sometimes, when Public Choice allows, this can be a proxy for happy customers. But it’s rare enough that you shouldn’t count on it happening.

  • 2 Dave M. // Nov 22, 2010 at 9:28 pm

    “Deflation refers to a decrease in the overall price level, which obviously does make “the stuff” cheaper.”

    Sorry, Jodi. Can’t back you up here. As Friedman proved, inflation and deflation are “always and everywhere a monetary phenomenon.”

    Imagine you had a static money supply. The only thing that would decrease prices are reductions in demand or efficiency gains (i.e., increases in supply).

    Focusing on the latter: what happens when there are efficiency gains? Well, whoever made them cuts costs and makes a killing on the market. More people are priced into a market they previously couldn’t afford.

    But it’s doubtful that, in the long run, that all the resources that used to go into that sector before the efficiency gains will remain there. Instead, those resources chase down new or existing industries where the use of those resources are more valued.

    With prices lower, the value of money goes up, and thus quality of life goes up. In short, deflation is not inherently bad, assuming a static money supply.

    Where deflation does go wrong is only where one holds debt and where one experiences a decline income. As the value of money increased, income decreased, but the value of the debt increased. Thus, the debt will now take longer to pay back, if it can be paid at all.

    This stresses not the need for stable prices, but for a stable monetary system, and also the need to not take on long-term debt.

    This is why this recession has been such a pickle. Time to return to economic fundamentals.

  • 3 Dave M. // Nov 22, 2010 at 9:43 pm

    Also, Scrooge McDuck doesn’t like inflation:

  • 4 econgirl // Nov 22, 2010 at 9:55 pm

    Update: Scott Sumner has his own version, which is entertaining for the awkward pauses if nothing else:

    http://www.xtranormal.com/watch/7687255/

    @ Dave M: By “cheaper” I mean nominally cheaper, not cheaper in real terms. I think that puts us more on the same page.

  • 5 econgirl // Nov 22, 2010 at 9:56 pm

    And of course Scrooge McDuck doesn’t like inflation- in a logistical sense, he is wedged firmly between the trust fund baby and senior citizen categories described above. :)

  • 6 Dr. John Swenson Harvey // Nov 23, 2010 at 2:41 am

    Just a note: Friedman mathematical showed that if one makes a lot of assumptions about market efficiencies, information, and the permanent income hypothesis that inflation/deflation is solely a monetary phenomenon; however, the inflation/unemployment caused by the 1973 through 1981 oil price shocks, and the Great Depression in general show that what is proved in theory doesn’t necessarily work in reality. U.S. markets are sticky and as a result equilibrium can occur at unexpected price and real output combinations. Since we have had persistent near 10% unemployment for quite some time here in the U.S. the labor market and the level of wages obviously are not, at the moment, behaving as classical/monetary economists predict.

  • 7 econgirl // Nov 23, 2010 at 3:32 am

    Precisely- this is what I meant above when I was, perhaps improperly, referring to classical economists. Friedman and others reach their conclusions based on assumption of completely flexible wages and prices, which, at least based on the evidence that I can see, isn’t particularly reasonable, since it appears that, at the very least, wages are not particularly flexible in the downward direction.

  • 8 Larry Signor // Nov 23, 2010 at 10:05 am

    I would like to introduce the idea of structured inefficiency to the conversation. QE seems to be an introduction of inefficiency to a cash positive balance sheet, thereby incentivizing investment as opposed to savings. This FRED graph (http://research.stlouisfed.org/fred2/graph/?s1id=OPHPBS) indicates the need for introducing inefficiency to the labor market, as well. Increasing the efficiency of labor is creating de facto unemployment. This is counter intuitive to most people, but if full employment is the goal, some inefficiency must be tolerated.

  • 9 Larry Signor // Nov 23, 2010 at 10:06 am

    http://research.stlouisfed.org/fred2/graph/?s1id=OPHPBS

  • 10 Dan L // Nov 23, 2010 at 1:29 pm

    Here’s my simple-minded, uneducated take on inflation and deflation. Assuming that both phenomena occur completely uniformly (affecting all prices and wages equally, no stickiness or whatever), I always thought that the main issue was saving vs spending. High inflation encourages too much spending and too little saving, while deflation encourages too much saving and too little spending. Both of these problems can be destructive to an economy.

    However, savings comes with an interest rate, so it would seem that the only thing that *really* matters is the difference between interest rates and the rate of inflation. To the extent that interest rates track the rate of inflation (or to the extent that it can be forced to do so), it would seem that the only relevance of inflation/deflation is a battle between debtors and creditors (which is a fairness issue as well as a purely economic one). Of course, interest rates, being positive, cannot fully track deflation.

    The other problem that I always thought economists feared was that both deflation and high inflation are self-perpetuating. Which brings me to my next point: The thing that generally confuses me (a layman) about macroeconomics is that it seems impossible to separate causes and effects, or in other words, to understand what variables can be safely held constant in analyzing economy. For example, if you ask the question, “What is the effect of a high rate of inflation,” does that question even make sense without understanding what causes inflation in general, and what caused this bout of inflation in particular?

  • 11 Dan L // Nov 23, 2010 at 1:52 pm

    Wait, you have a mortgage in Cambridge as a lowly graduate student?

  • 12 Matt H. // Nov 24, 2010 at 10:08 am

    So let me get this striaght. Americans hate unemployment; they bark incessantly that politicians need to fix the problem. Inflexible wage rates often result in unemployment instead of wage rate adjustments. Inflation allows for firms to profit from wage stickiness and slowly but surely reduce unemployment. But targeting inflation is some type of big government, irresponsible, steal the value of our money play?
    I find myself siding with Sumner quite often on these matters, though I don’t fully grasp the NGDP level targeting he’s always promoting.

  • 13 Amarsir // Nov 27, 2010 at 3:28 am

    Lately I’ve been trying to learn more about John Taylor’s inflation targeting rule. I believe a fair summation is that it’s less important what the rate is than that it be held steady, because markets will adjust allocation for high or low inflation, but become imbalanced as a result of major shifts. (The S&L Crisis and Housing Bubble being two fairly compelling examples of this.)

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