Inflation in a Nutshell
Posted by Robert Whaples on November 10, 2009
On Friday and Monday, I covered Cowen and Tabarrok’s chapter “Inflation and the Quantity Theory of Money.” The chapter begins by defining and measuring inflation. There’s an excellent table enumerating episodes of hyperinflation (although I didn’t see a clear definition or rule of thumb as to what constitutes hyperinflation). It then immediately cuts to the chase: what causes inflation? The quantity theory of money is explained unusually clearly and is supported convincingly with international data. I especially liked the “quantity theory of money in a nutshell” summary in the margin of page 222, exactly the way I frame things in class . Disinflation is distinguished from deflation — nice touch.
The chapter concludes with a lengthy discussion of the costs of inflation, with considerable attention paid to how inflation redistributes wealth, especially how expected and unexpected inflation help determine nominal interest rates and actual rates of return. When presenting this topic in class I always emphasize that high inflation is associated with variable rates of inflation and this causes uncertainty which cows investors and businesses to sit on their hands. High inflation causes uncertainty which shrinks total output. Here’s how I put it in class: “In the high inflation 1970s the CPI inflation rates were – rounding to the nearest digit – 6, 3, 3, 9, 12, 7, 5, 7, 9, and 13 percent. When the numbers bounce around a lot like this, it’s hard to know what’s coming next. In 1979, it would have been pretty hard to predict that the inflation rates in the next three years would be 12, 9 and then 4 percent, for example. Compare this to the lower inflation rates beginning in 1995. These inflation rates were much less variable – rounding to the nearest digit, they were 3, 3, 2, 2, 3, 3, 2, 3, 2, and 3. Given this trend it wouldn’t have been hard to come close in guessing the inflation rates of the next couple of years – which were about 3 and 3.”
If I were to add anything to the chapter, it would be a brief (perhaps one-page) discussion of problems with measuring inflation correctly and the whole CPI bias literature. I introduced this topic in class and used Dora Costa’s estimates of bias to adjust the official CPI numbers given in Figure 11.3 of the text. Incorporating the bias (which compounds year after year), the price of the market basket rises from $10 in 1914 to about $85 in 2008, rather than from $10 to $207. Big difference.
Disappointment: On Monday’s quiz I posed this question to students — “The current price of a barrel of oil is about $80. The (nominal) price in late 1979 was $38. In 1979 the CPI was 77. Today the CPI is 216. Has the real price of oil risen or fallen since 1979? Explain.” Only about half of them did a good job in answering the question, which suggests that the text might do a little more on page 220 to explain how to answer this question.