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Pumping Up & Down

By Kevin

One is Enough

In the recent financial page of The New Yorker, James Surowiecki, talks about central banks' overly enthusiastic fears of inflation. He even included notes for this particular column on his blog, to demonstrate how inflation hawks have been crying out loud. There is just something peculiar about the way we economic agents treat price changes - we are always too nonchalant about it or way overboard when fearing it. There will always be 2 camps of people in the economy, one group with huge fears of inflation, making a whole lot of noises when monetary policy is expanding and credit is loosening while another bunch would find deflation looming in the same economy and decry tightening of government expenses in the economy. And because these people almost always seem to be some sort of economist or economics-trained characters, this phenomenon seems to demonstrate the two-handedness of economists so frowned upon by Harry Truman.

The fact is that price changes are incredibly impossible to foresee although classical economists believes that price changes can be calculated by looking at the general system of the economy. Their famously simplistic equation of PQ = MV (Price, Quantity, Money, Velocity). PQ represents the national income, commonly measured using the GDP. And classical economist always seem to believe that output is max-ed out (that is no excess capacity) and that velocity of the cycling of money is more or less consistent and so money supply almost definitely mean price increases. In other words, monitor the money supply of the economy, the policies of the central bank and we'll know the price changes.

Alas, the real world isn't that simply since the velocity of money is dependent on the circumstances of the economy. In a recession, the build up of reserves in banks and the savings of consumers inevitably mean that consumption is slowing and the velocity of money reduces. Likewise, when output is not maximized and there is still plenty of excess capacity, the increase in money supply can translate into real growth (that is the Keynesian idea of a stimulus that boost aggregate demand and create real growth in short run). So we can't be sure the effect of policies on prices exactly; usually we believe that there's an influence on both output and prices.

At the end of the day, I guess pumping up is safer than going down given the fact that our policy tools to combat inflation is way sharper than for deflation. In any case, these price changes usually only gets wild when there's something wrong about the fundamentals of the economy (lacking diversity of markets, overly dependent on a single market, growth guided by short-run policies and so on).