A barter economy can have all of these attributes:
1. Oil shocks
2. Crop failures
3. Powerful labor unions
4. Budget deficits
5. Supply bottlenecks
6. Corporate greed
7. A strong economy with no “slack”
These are also factors that are widely seen as causing inflation. So what sort of inflation rate should we expect to see in a barter economy that features all seven of those attributes?
Zero.
Not approximately zero—precisely zero.
Inflation is the average change in the price of goods. In a barter economy, the average amount by which goods prices change is zero.
Consider an example of a two good economy, apples and oranges. If the price of oranges rises from 2 apples to 4 apples, then the price of apples falls from 1/2 orange to 1/4 orange. The average price change is exactly zero. Barter economies do not experience inflation, even if they contain all seven of the widely believed causes of inflation.
Notice that I didn’t list monetary policy above. A barter economy cannot have a monetary policy, because it doesn’t have a monetary system. As soon as you add money to a barter economy, inflation magically becomes quite possible. Is it any surprise that for the past 300 years, the brightest economists (from David Hume to Irving Fisher to Milton Friedman) have focused on the role of money in creating inflation? It is literally impossible to have inflation without money. Why wouldn’t monetary policy be important?
By definition, inflation is the percentage decrease in the value of a unit of base money, i.e. the fall in its purchasing power. Are you surprised that an entity with a 100% monopoly on the supply of base money, and also an ability to strongly influence demand for base money (via interest on bank reserves), would be able to control the value of base money?
READER COMMENTS
Ahmed Fares
Aug 13 2023 at 7:24pm
When you introduce money into a barter economy, you end up with a second problem in addition to inflation (which I just learned thanks to reading Scott’s article), which is unemployment:
—Professor Paul Davidson (University of Tennessee – PKT Archives)
Scott Sumner
Aug 13 2023 at 10:33pm
In theory, you could get unemployment if wages were sticky in commodity terms. But in practice barter economies tend to have flexible wages. So yes, you would not expect involuntary unemployment.
nobody.really
Aug 14 2023 at 6:35pm
I hadn’t thought about it before. Does anyone have evidence on this topic?
Andrew_FL
Aug 14 2023 at 12:58am
Another way of saying this might be that barter is so inefficient at realizing gains from trade that the main problem is involuntary employment, and/or under realization of leisure because everyone has to do all the work they can’t trade with other people for the output from.
All the barter economy examples are also examples where almost all output is just agricultural, and the people who aren’t in some form of forced labor are self-employed just producing their own food. The better question is, are there actually business cycles in pure or primarily agricultural monetary economies?
vince
Aug 13 2023 at 8:17pm
So the Fed only needs to increase IOR to end inflation? Too simple.
Scott Sumner
Aug 13 2023 at 10:36pm
They need some combination of lower supply of base money and increased demand for base money. There are many combinations that work. It’s not that the Fed doesn’t know how to end inflation, rather they are being careful to try to avoid high unemployment when doing so. Maybe too careful. They could end inflation tomorrow.
vince
Aug 13 2023 at 11:16pm
There are many persuasive discussions that the Fed is too weak to control inflation. The only money aggregate it controls is base money, and the only rates it controls are IOR and FFR. The bond market raised rates before the Fed.
Scott Sumner
Aug 14 2023 at 1:45am
“The only money aggregate it controls is base money, and the only rates it controls are IOR and FFR.”
That’s more than enough to be able to control the price level. There are no persuasive arguments that the Fed cannot control the price level.
Dylan
Aug 14 2023 at 6:18am
I find the fact that they haven’t controlled the price level very well throughout their history pretty convincing.
Jon Murphy
Aug 14 2023 at 7:45am
Scott’s point is that the Fed has the tools, they’re just not using them fully. That’s not the same as being unable to control the price level.
By way of metaphor, not applying the breaks in a car does not mean one is unable to control the speed of a car.
Richard W Fulmer
Aug 14 2023 at 10:46am
The Fed has become the lender of last resort for the government as well as for banks. When demand for government debt has fallen, the Fed stepped in to purchase it, thus underwriting the federal government’s deficit spending and (not incidentally) fueling inflation. Theoretically, the Fed could refuse to purchase any more government debt so, technically, you’re correct, the Fed can control the price level. However, can the Fed do that in practice? What would happen if it stopped buying government paper?
vince
Aug 14 2023 at 12:00pm
On interest rates, the argument is that the fed controls only very short term rates and influences only an insignificant portion of credit markets.
On the money aggregates, the arguments are that velocity is too unpredictable, and the monetary base is too uncorrelated with broader aggregates–even more now without reserve requirements.
One additional argument is fiscal dominance.
vince
Aug 14 2023 at 12:05pm
Jon, I agree with you and with Scott if that’s his point, but that raises an important question: Why doesn’t the Fed use the tools that it has? An example is the reserve requirement. Instead of scrapping it, it could have been expanded.
vince
Aug 14 2023 at 12:08pm
You can add stock markets to that list.
Scott Sumner
Aug 14 2023 at 2:07pm
Dylan, You said:
“I find the fact that they haven’t controlled the price level very well throughout their history pretty convincing.”
They only began targeting inflation around 1990 (at roughly 2%.) Since then inflation has averaged 2%. Is that some sort of miracle, or did the Fed cause that? Yes, there’s been more variation than would be desirable, by why be surprised that government bureaucracies make mistakes? You think the Fed is unable to reduce the money supply? Why?
Scott Sumner
Aug 14 2023 at 2:12pm
Vince, IOR does not work by affecting longer term rates, it works by affecting the demand for base money. I rise in IOR often reduces long term rates—at leas tif it reduces inflation expectations. Monetary policy is not the same as market interest rates. IOR is not a market interest rate.
Velocity can change, but that doesn’t prevent the Fed from controlling inflation.
vince
Aug 14 2023 at 2:30pm
This goes back to the question of how much credit to give the Fed for low inflation. Greenspan attributed low inflation after 1990 to globalization, so much so that he had little concern for inflation. He left in 2006? One year later we had the worst recession since the Depression, and I’m not sure we have ever fully recovered from it. The ample reserves regime is an example.
Jeff
Aug 14 2023 at 8:10pm
Doesn’t the Fed’s ability to control the price level rely on their ability to defy the (in theory, potentially even bipartisan) desire of the political organs of government to monetize spending?
I submit that this is a harder task than refusing to monetize defaulted debt in the event the debt ceiling is breached. Because, in that case, you are simply refusing to clean up the mess of a divided political system rather than standing athwart a unified one. Yet Powell described the possibility of the Fed buying defaulted debt as “loathsome”. Which, reading between the lines, seems to suggest that it is something they would have held their nose and done, regretting it mainly because it would look bad for them and damage their credibility.
That would seem to be a persuasive argument that the current leadership lacks either the willingness or ability to control the price level.
Scott Sumner
Aug 15 2023 at 3:03pm
Vince, Greenspan was clearly wrong, as NGDP growth came down by roughly the same amount. It was monetary policy that reduced inflation.
vince
Aug 15 2023 at 6:00pm
That reminds me of a 2021 paper on inflation by Greenwood and Hanke about cheap imports and inflation. Goods prices decreased, but domestic service prices more than offset that decrease. They attribute the overall price increase to monetary policy, specifically money supply growth.
They also predicted persistent inflation 2022-3 in response to the growth in money supply 2020-1.
Dylan
Aug 16 2023 at 10:39am
@Scott, I admit that my comment was meant a little bit snarky and was trying to bring into account some public choice elements into the discussion. But, the quoted part is new to me. I don’t have nearly the knowledge of the Fed that you do, but I was under the impression that the “dual mandate” dates back at least to the late 70s? Didn’t the 1977 Federal Reserve Act specifically require the Fed to target stable prices as part of the mandate? What changed around 1990?
Don Geddis
Aug 14 2023 at 10:49am
The Fed does not control the FFR. The FFR is a free market rate. The Fed targets the FFR, it does not control it.
Once you understand how the Fed is able to cause the FFR to float to the Fed’s target value (hint: via Open Market Operations which change the quantity of the base money supply), you may come to understand how the Fed is similarly able to control other nominal variables in the economy (like aggregate demand or inflation).
vince
Aug 14 2023 at 12:21pm
Maybe control is too strong, but IOR puts the floor on FFR. The Fed controls aggregate demand and inflation? Then we should never have problems with either one.
Scott Sumner
Aug 15 2023 at 3:04pm
Vince, A steering wheel controls the direction of a car? Then we should never have traffic accidents.
vince
Aug 15 2023 at 5:05pm
Bad steering isn’t the only cause of accidents. Regardless, it depends on what you mean by control. Don said the Fed does not control the FFR. But then he said the Fed controls aggregate demand and inflation. Doesn’t the Fed have more control over FFR than it does over aggregate demand or inflation?
Don Geddis
Aug 15 2023 at 7:45pm
@vince: The Fed directly sets certain variables under its direct control. It sets IOR (and IOER), it sets the discount rate at the discount window, it sets the quantity of base money (via Open Market Operations).
Because of this control over the (base) money supply, the Fed indirectly controls any (single) aggregate nominal variable in the economy. But the trick is: it only has (essentially) one tool, so it can only (indirectly) control one variable at a time.
But it could successfully target: the FFR, the prime interest rate, aggregate demand (NGDP), inflation, the (dollar) exchange rate with the Euro, the price of oil (in dollars), the price of gold (in dollars) … even the price of grapes or concrete or iPhones.
The mechanism is trivially easy: if the current market price of your preferred item is below target, increase the money supply. If the current market price is above target, decrease the money supply (or at least its growth). Continue doing this until the price level changes sufficiently so that your preferred item’s market price floats to your desired nominal target.
Monetary policy is pretty simple.
Scott Sumner
Aug 16 2023 at 9:25pm
“Bad steering isn’t the only cause of accidents.”
Yes, but it is the cause of most accidents, especially when combined with other things the driver controls, like the accelerator pedal. (The rest are due to brake failure, etc.)
Thomas Hutcheson
Aug 14 2023 at 9:40am
If in addition to those things the “barter” economy also has some relative prices that could not easily adjust to changed in supplies or demands, then it would be subject to all the inefficiencies that excessive causes as well as the inefficiencies that insufficient inflation causes.
I strongly recommend having a central bank that at least tries to facilitate relative price changes, even if, being human, it will often fail.
Jon Murphy
Aug 14 2023 at 11:49am
It’s not clear to me how that could come about in a barter economy.
Thomas L Hutcheson
Aug 14 2023 at 9:18pm
A offers B 5 apples to work a day (yesterday he received 6) and B refuses and remains unemployed because of the sticky relative price.
Greg G
Aug 15 2023 at 7:27am
Ok but then hasn’t the price of apples inflated by exactly the same amount that the price of the labor in question has deflated leaving the average price level the same?
Scott Sumner
Aug 14 2023 at 2:08pm
Richard, You said:
“The Fed has become the lender of last resort for the government as well as for banks.”
False, the Treasury doesn’t have any problem selling debt to the public.
Richard W Fulmer
Aug 14 2023 at 4:15pm
That is certainly true today. But it wasn’t true at the beginning of the COVID pandemic. Sales of treasury notes fell, and the Fed stepped in to bolster demand.
Scott Sumner
Aug 15 2023 at 3:07pm
Actually, market interest rates plunged during Covid. The Fed was providing liquidity to maintain its inflation target, not supporting the government bond market.
vince
Aug 15 2023 at 5:18pm
From March 9-18 the 10 year treasury surged 64 basis points. The Fed implemented a program to purchase $1 trillion in Q1. Whether you call that a program to provide liquidity or to bolster demand seems to be semantics.
Scott Sumner
Aug 16 2023 at 9:21pm
Yes, ten year yields surged to the stratospheric level of 1.12%. The Fed certainly wasn’t buying T-bonds because they thought the Treasury would go broke paying 1.12% interest on ten year bonds.
People buy T-bonds when they fear the US economy is going into a deep slump. The Fed’s mandate calls on them to print enough money to prevent the economy from going into a deep slump. They do so by purchasing Treasury debt. That’s their job. It has nothing to do with supporting T-bond prices, which even at 1.12% were far lower than during 2019.
Perhaps that argument applied during WWII, but not today.
BTW, Treasury yields recently shot up by more than 68 basis points, to well over 4%. But I doubt the Fed will buy lots of T-bonds this year.
vince
Aug 16 2023 at 9:55pm
You can interpret it that way, but it doesn’t actually say that. The Federal Reserve Act just says the Board, the FR System, and the FOMC shall maintain long run growth of monetary and credit aggregates commensurate with potential to increase production … so as to promote goals …
In retrospect, the reaction to COVID is looking like hysteria.
Also, 64 basis points when rates are less than half a percent isn’t comparable to 64 basis points when rates are 4 percent.
Roger McKinney
Aug 15 2023 at 10:36am
Excellent points! If people can grasp this, they will be far better economists than most mainstream economists.
Hayek called money a loose joint because it loosens the tight relationship between quantity supplied and prices.
But money isn’t the problem. A pure gold standard would not create significant problems unless large new supplies are discovered. Problems arise with fractional reserve banking and lending.
Scott Sumner
Aug 15 2023 at 3:08pm
A gold standard wouldn’t work well today because the demand for gold is too unstable.
Roger McKinney
Aug 16 2023 at 10:33am
I’m not arguing for a gold standard. Governments thwarted it at every turn when we had it.
But couldn’t the “unstable” demand for gold be the result of wild swings in monetary policies?
Besides, why is the stability in the demand for gold a criterion for its use? The demand for gold should change with changing economic circumstances, technology, taxes, tastes, etc. That’s how it would be good money.
Scott Sumner
Aug 16 2023 at 9:22pm
Money doesn’t work well when its value is very unstable.
Roger McKinney
Aug 17 2023 at 3:00pm
Gold’s value us stable. It’s the dollar’s value that isn’t stable.
Scott Sumner
Aug 18 2023 at 1:40pm
No. Over the past few decades, gold’s purchasing power has been far less stable than the US dollar’s purchasing power.
Markus Murphy
Aug 22 2023 at 4:49pm
What happens when we add a “Gang that demands tribute”, a “warlord”, a “government” to our apples and oranges economy?
If tribute/rents/taxes are required in oranges (or apples) doesn’t that bring inflation/deflation and at least some, maybe all of Scott’s list into play?
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