Inflation is a nominal phenomenon
By Scott Sumner
In my previous post, I discussed how Milton Friedman was right about 4 key issues during the 1960s and 1970s. He argued that interest rates are not a good indicator of the stance of monetary policy. He argued that the long run Phillips Curve was vertical, which means no long run tradeoff between inflation and unemployment. He argued that fiscal policy was not an effective way to control inflation. And he suggested that wage/price controls would not work.
But why was he able to see what other top economists failed to see? What do these four cases have in common? Perhaps conventional economists were putting too little emphasis on the distinction between real and nominal variables. Friedman saw that persistent inflation is a nominal problem, and it has nominal causes.
Edward Nelson (vol. 2, pp. 155-56) quotes Friedman in 1977, looking back on his 1967 Presidential address:
The essence of my argument in that paper was that the monetary authorities had a monetary instrument with which they could ultimately control only monetary variables, such as the price level and nominal income; that it is not possible to use monetary instruments to achieve a real target, whether that real target be the real interest rate or real output or unemployment rate.
When analyzing inflation, Keynesians were explicitly or implicitly focused on 4 real variables:
1. real interest rates
3. the velocity of money
4. price mark-ups (in percentage terms)
1. In the 1960s, Keynesian wrongly assumed that rising nominal interest rates represented rising real interest rates, and hence “tight money”. There are actually two problems here. The obvious problem is that nominal interest rates might be rising due to inflation (the Fisher effect.) The less obvious problem is that although tight money often does temporarily increase real interest rates, it is not true that rising real interest rates imply tight money. Real interest rates move around for many different reasons. And finally, for any given money supply, higher nominal interest rates are actually inflationary, as they boost velocity.
2. Keynesians wrongly assumed a long run tradeoff between inflation and unemployment. While it is true that a tight monetary policy raises unemployment in the short run, it is not true that rising unemployment implies tight money, or lower inflation (as we saw in the 1970s.) For any given level of nominal GDP (M*V), a booming economy is actually deflationary. Low unemployment can co-exist with low inflation, as we saw in 2019. High unemployment can co-exist with high inflation, as we saw in 1981.
3. Keynesians typically don’t talk about velocity. But the claim that fiscal policy can control inflation is implicitly a claim that fiscal austerity reduces velocity. Nominal spending is M*V, so if you don’t plan to control the money supply, the only (demand-side) way to reduce inflation is by reducing velocity. Friedman didn’t think fiscal policy had much effect on velocity, and even if it did, it would at most be a modest one-time effect. If the Fed boosts the growth rate of the money supply from 5%/year to 10%/year (at a time of positive interest rates), you are almost certainly going to eventually end up with higher inflation. Even if a tax increase reduces the velocity of circulation by 2% in a single year, it will have almost no impact on longer run inflation, which is driven by rapid money growth.
Here’s very important distinction. If you boost money growth from 5% to 10%/year, if will cause inflation to be roughly 5% higher as long as the rapid money growth continues. Fiscal policy is not like that. Even if you permanently switch to a more expansionary fiscal policy, it will only cause a one-time increase in velocity. Monetary policy works by influencing a nominal variable (M), while fiscal policy works by influencing a real variable (V). It’s really hard to cause persistent inflation by influencing real variables like velocity. In contrast, it’s easy to increase the money supply growth rate as much as you like.
4. The same argument applies to price controls. Let’s say that firms have some monopoly power and that price controls are able to reduce price mark-ups by 2%. That merely produces a one-time 2% fall in the price level, relative to where it would otherwise have been. Go much further with price controls and you end up with severe shortages. But if the Fed is simultaneously boosting money growth from 5%/year to 10%/year, the disinflation effects of the price controls will be overwhelmed by the effects of faster money growth. That’s the story of the 1970s.
To summarize, Keynesians were treating inflation like it was a microeconomic problem, which could be addressed by influencing real variables. It’s true that if you want to lower the relative price of a single good in the economy, you need policies that impact real variables. But inflation is a nominal phenomenon, and it requires nominal solutions. You need to reduce the growth rate of the nominal money supply.
In some respects the Keynesian mistake was understandable. Between 1879 and 1968, the price of gold was fixed, except during 1933-34 when it rose from $20.67/oz. to $35/oz. During much of that long period, people tended to think in terms of high and low price levels, not high or low rates of persistent inflation. In a world where price levels bounce up and down and inflation is not persistent, the four Keynesian fallacies discussed above are much less of a problem. Real and nominal interest rates are similar, the Phillips Curve is more stable, tax increases can slightly reduce the price level during a period of high prices, and price controls can have a modest effect during a temporary price level surge.
But if the inflation rate rises from 2% to 8%/year, and the high inflation persists for a long period, then real theories of inflation become almost worthless. It’s a monetarist world, and Milton Friedman was the master of that world.
PS. Some of these arguments are less applicable to a world of zero interest rates. But Friedman was winning his arguments with the Keynesians at a time when nominal interest rates were far above zero.