Posts Tagged ‘prive level’

The price level – is it explained by the QTM – or is it rather the other way around?

first postet: Fri Jul 22, 2011 10:19 pm

Scott Summner insist that the QTM is a good explanation of the price level.
He then creates a fictive economy with a fixed amount of currency and states:

„It’s likely that NGDP will end up being roughly 15 to 50 times the value of the stock of currency.“

Of course, 15 to 50 times are not a really precise figure, not even as „ballpark“ – it’s a factor of 3.3 – so the same quantity of money can have a) stable prices, b) 300 % inflation, or c) serious deflation? – So what does it explain?

He further states:

“BTW, prices in Japan are 100 times higher than in the US, and Korean prices are 1000 times higher.”

Are they? AFAIK, all these countries have their own currency, so there is no common denominator. Comparing “Price levels” without noting that they use different units of account is rather pointless – not all currencies are “created equal”. That’s why there are currency exchange rates. Only if you compare prices (in different currency) at their exchange rate can you compare price levels.

The actual price levels (in local currency) are the result of economic history. Comparative price levels are usually explained by the rate of productivity in the tradable goods sector. If productivity in the tradable goods sector in country A) is high, those producers can easily compete on global markets, make a lot of profit and pay good wages. This should create a high demand for labor in this sector (pull workers out of less productive sectors), and (due to the high wages/profits earned in the TGS) more demand for non tradable domestic goods and services (like housing, haircuts, dining out etc.).

So, higher demand for non-tradables, and wage pull from the tradable sector, will pull the wage level up, and with this the general price level. So country A) – due to its higher productivity in the TGS should have a higher price level than country B). (And of course, it has a fair chance to have a trade balance surplus, so money flows in to the country, which expands the quantity of money – but this is an effect – and not the cause).

So – what else causes inflation (and deflation)?

If demand rises, and supply is inelastic, or, if supply falls, and demand is inelastic, supply will fall short of demand, and hence, prices will rise. Now, how can this be, if the quantity of money is stable?

Well, some call it velocity, others call it leverage. Anyhow, people, chasing the rare goods, either liquidate savings, or take credit, to keep buying.

If supply later becomes adequate again, prices should drop somewhat (but not all the way), but the private sector will be more in debt (relative to GDP) than before.

If supply stays inadequate for some time, there are two possibilities. If the net money supply doesn’t increase sufficiently, then credit expansion will come to an end, there will be a demand shock, and recession (and quite possibly, deflation) will follow. If, OTOH, government runs a persistent deficit, which adds to net financial assets of the private sector (that is – increases the net money supply), then the rise in the price level (inflation) might persist, and if supply remains insufficient for quite some time, both deficit and private credit expansion can finally result in hyperinflation.

Or, to put it in other words: an increase in the quantity of money might follow inflation, and an expansion in the net quantity of money (trough new gold mined and minted, a trade balance surplus, or –rather the norm – a government deficit) is a prerequisite for a persistent rise in the price level – but it’s not the cause, it might be an effect.

If – say under a gold standard – the amount of money is fixed, the price level can’t rise persistently – but it will fluctuate wildly – supply shocks will result in higher prices, but those will soon be offset by demand shocks (or just normalization).

Increasing the money supply trough central bank lending to private banks doesn’t increase the NET financial assets of the private sector (both assets and liabilities of the banking sector increase). An increase in net financial assets of the private sector can only derive from a government deficit or a trade balance surplus (or, if the central bank directly buys NON FINANCIAL ASSETS – like houses, roads, commodities, or labor..).

Paying interest on reserves is nothing but a bank subsidy. [In a similar way, paying interest on treasury bonds is a subsidy to bondholders..] And QE is just a special form of subsidy for bondholders – if they can now sell bonds at a market price above parity to the FED, instead of waiting till the bonds are finally redeemed at par at maturity.