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A Fall in Purchasing Power? The Inflation Fallacy

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ThatOldGuy Posted: Sun, Dec 16 2012 11:07 PM

I don't even.

 

From Principles of Economics by Mankiw:

If you ask the typical person why inflation is bad, he will tell you that the answer is obvious: Inflation robs him of the purchasing power of his hard-earned dollars. When prices rise, each dollar of income buys fewer goods and services. Thus, it might seem that inflation directly lowers living standards.

Yet further thought reveals a fallacy in this answer. When prices rise, buyers of goods and services pay more for what they buy. At the same time, however, sellers of goods and services get more for what they sell. Because most people earn their incomes by selling their services, such as their labor, inflation in income goes hand in hand with inflation with prices. Thus, inflation does not in itself reduce people's real purchasing power.

People believe the inflation fallacy because they do not appreciate the principle of monetary neutrality.

 

Thoughts? Comments?

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Prime replied on Sun, Dec 16 2012 11:26 PM

Thats odd, the corporation I work for has had wage freezes for over 4 years now. Unfortunately, the prices I pay for goods did not.

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Because most people...

A concession right here. He admits that some people will lose.

...inflation in income goes hand in hand with inflation with prices

Key phrase here is hand in hand. The two go don't go hand in hand at all. See link below.

...the principle of monetary neutrality.

Which is fallacious. The Non-Neutrality of Money.

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Neodoxy replied on Sun, Dec 16 2012 11:52 PM

*Facepalm*

Do we really have a major economist promoting money neutrality? The only way that this would be true is if everyone received the money first, spent it in the same way, and at the same time. Because this will never happen money will never be neutral. I also overlooks the general effects that this will have on savers who did not anticipate the inflation.

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Wheylous replied on Mon, Dec 17 2012 12:10 AM

He's talking about the long-run, not the short run. Even in the long run, Austrians point out that there are losers depending on where the money is injected and when it's spent.

However, I think it's unfair to not concede that wages will increase to compensate for increases in inflation. They will not increase uniformly and completely, but they do increase in the long run.

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Jargon replied on Mon, Dec 17 2012 12:31 AM

If we assume a single 'wave' of inflation. Try having inflation set as a perpetual policy. Plus wage rates aren't really effectively bargained over without a clever union and a lot of people aren't unionized.

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Wheylous replied on Mon, Dec 17 2012 12:35 AM

wage rates aren't really effectively bargained over without a clever union

Really?

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Jargon replied on Mon, Dec 17 2012 12:49 AM

Has anyone's boss ever said to them "Hey QE3 just came out and prices are going to rise a little bit, so here's a $1.50/hr raise!"

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Wheylous:
He's talking about the long-run, not the short run.

Oh I get it.  So kind of like a "[no one really gets hurt because] in the long run we're all dead."  Nice.

Keynes' statement has to be one of the dumbest of all time.  If there was a list of the most useless, moronic things ever said, that would definitely be on it.

Anytime someone uses that I'll just wait to hear something they wish to complain about and then proudly tell them how their petty concerns are irrelevant, and why.

 

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Mankiw goes into methodological holism on the first page of the book:

The word economy comes from the Greek word for “one who manages a household.”
At first, this origin might seem peculiar. But, in fact, households and
economies have much in common.
A household faces many decisions. It must decide which members of the
household do which tasks and what each member gets in return: Who cooks dinner?
Who does the laundry? Who gets the extra dessert at dinner? Who gets to
choose what TV show to watch? In short, the household must allocate its scarce resources
among its various members, taking into account each member’s abilities,
efforts, and desires.
Like a household, a society faces many decisions. A society must decide what
jobs will be done and who will do them. It needs some people to grow food, other
people to make clothing, and still others to design computer software. Once society
has allocated people (as well as land, buildings, and machines) to various jobs, it must also allocate the output of goods and services that they produce. It must
decide who will eat caviar and who will eat potatoes. It must decide who will
drive a Porsche and who will take the bus.

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MMMark replied on Mon, Dec 17 2012 9:22 PM

Mon. 12/12/17 22:22 EST
.post #240

Then of course, there's bracket creep:

A situation where inflation pushes income into higher tax brackets. The result is an increase in income taxes but no increase in real purchasing power.

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Wheylous replied on Mon, Dec 17 2012 9:41 PM

Tax brackets are indexed to (price) inflation, according to Mankiw.

Oh I get it.  So kind of like a "[no one really gets hurt because] in the long run we're all dead."  Nice.

No, as in "the quantity theory of money works in the long term."

I think we can agree that while employers might not want to immediately increase wages, in the medium to long run they will have to because of the real factors of production involved requiring equilibrating.

I am amazed that Neodoxy isn't backing up Mankiw on this one. It's not really that controversial a point.

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Wheylous replied on Mon, Dec 17 2012 9:48 PM

Alternatively, take the equation of the quantity theory of money:

MV=PQ

M is the money supply

V is velocity

P is price level

Q is quantity produced

PQ may be simplified as Y, GDP.

so MV=Y (easier to look at)

This is an identity, because the velocity of money is defined as the average number of times a dollar bill is used in exchange, or V=Y/M.

If you assume that monetary policy cannot increase GDP in the long run, then if you have MV=PQ and you increase M, then assuming a constant V you will either need to increase P or Q. Since by assumption monetary policy doesn't affect long-term production, P must increase. It's curious why you'd think that the price level may increase without wage levels increasing as well (in the long run). It's basic micro that wages must be bid up.

Mankiw's saying pretty standard stuff. He's not simply spouting off money neutrality.

Now, he may neglect the effect that monetary policy might have on the business cycle, but over the long term inflation doesn't affect income as much as a non-economist might think.

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z1235 replied on Mon, Dec 17 2012 10:16 PM

If I could counterfeit $1Trillion a day for a year, and used them to bid for goods and services against you, then your income's purchasing power would diminish than slowly stabilize over the next ten years, depending on how far your labor/service is removed from the goods/services I'm buying with the new money. So sure, "in the long run" your income's purchasing power may eventually adapt to the new money supply (in ten years). That doesn't contradict the fact that I have literally stolen huge amounts of your labor's productivity in the meantime. Money neutrality, mu a**.

 

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Wheylous replied on Mon, Dec 17 2012 10:20 PM

I don't disagree with that. The point is, however, that wages will increase eventually. During the time when they did not, there was misallcoation going on. I agree.

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Aristippus replied on Mon, Dec 17 2012 10:23 PM

If inflation is constant and I always receive the new money last, I never catch up.

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There are always natural and artificial costs included in the prices of everything. The most obvious artificial cost is government mandates.

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If the money-fairy magically doubled all cash balances overnight, there would be no economic impact. The reason that inflation in reality has an economic impact is that new money is not instantly and proportionally distributed to all holders of money. Inflation doesn't reduce purchasing power in general, it redistributes it from those who receive the money later to those who receive the money earlier.

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If the money-fairy magically doubled all cash balances overnight, there would be no economic impact.

Oh, but there would be. If she also doubled all amounts in all currently binding contracts (including debts), then we would be a bit closer to "no impact".

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Wheylous replied on Tue, Dec 18 2012 3:11 PM

Andris - I assume he meant both all money balances and all prices.

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idol replied on Tue, Dec 18 2012 8:51 PM

If money were neutral, banks would not care about the money supply. Also, how does he avoid addressing price stickyness, the unfair distribution of the printed dollars, or the fact that savers and people with no income are robbed without compensation?

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If you assume that monetary policy cannot increase GDP in the long run, then if you have MV=PQ and you increase M, then assuming a constant V you will either need to increase P or Q. Since by assumption monetary policy doesn't affect long-term production, P must increase.

P is not the price of every single item, right? Some things cost a dime, some cost millions of dollars. P is the average price of things. So the equation does not by itself prove that wages must rise, or that any particular item will have its price rise, only that the average must rise. Not sure why you brought it up.

Same flaw exists in the quote mentioned in the OP. He is trying to prove by a chain of reasoning that something must happen, [things going hand in hand] but the proof is flawed.

It's curious why you'd think that the price level may increase without wage levels increasing as well (in the long run). It's basic micro that wages must be bid up.

Why must they be bid up?

Of course, basic micro, when taught by a non Austrian, has to be approached with caution. Whenever govts, banks, inflation, taxes, and the like are analyzed, be on your guard. I mean, what's the whole point of having you attend their govt school if not to make sure you learn the govt world view?

Ghandi describes what he was taught in British schools as a boy. Can you guess what they told him about Indians?

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After I read that, all I could think was that even in the case of income inflation, those "sellers" are at the same time the majority of the buyers of those things which experience price inflation.
 

 

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The best reply to anyone who beleives inflation doesn't hurt due to "money neutrality" is that the same principle would apply to the "deflation" of a fixed money supply acquiring purchase power against a growing stock of consumer and capital goods.

Any neutrality based solely on the symmetrical situation of the buy and sell sides  would have to apply to falling prices as well, because the symmetry of transactions is not broken.

Therefore we would have no need for banks and government sponsered inflation.

But probably they would argue that people behave differently against falling prices, and some will hoard money and so on and so forth, intensifying things.

That might be true, but then the money neutrality is not solely based on the symmetry of transactions, but on a given set of psychological predispositions that are hard to verify but are nonetheless conveniently taylored to suit the inflationist view.

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