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How much our economy can sustain before inflation occurs

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Dustin Wassner posted on Wed, Apr 24 2013 8:41 AM

My econ instructor and I discussed inflation and gold prices. He made a comment about the ability of our economy to sustain increases in demand before inflation occurs because of the high unemployment. His explanation is that where we are on the supply curve, which becomes vertical as you move to the right is nowhere near the vertical area. I understand what he means by having unemployed resources in the economy which gives us the ability to sustain and easily increase supplies that are demanded. I also understand that when we are on the vertical area of the supply curve, nothing more can be supplied, so all that occurs with an increase in demand is an increase in price, which he defines as inflation. I also understand that his definition of inflation is not that of the Austrians. But, there must be more than what he is explaining. Any comments would be appreciated.

thanks

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See https://mises.org/daily/3290

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My humble take on all this:

He is talking about an Aggregate Supply and Demand curve.

When a supply curve is horizontal that means that an increase in demand, meaning moving the the demand curve to the right will not change the price of anything, because the intersection of the new demand curve with the supply curve is still at the same height, or price

The question is, why are we justified drawing the supply curve as horizontal in the first place? What kind of strange reality is that? After all, won't a given price induce exactly one quantity of suppliers? How can we say that for a whole range of possible values of supply, the price will stay the same? Won't competition reduce the price as supply increases?

Your prof's explanation is that we have high unemployment. Uncle Wikipedia explains. First, why the supply curve stays horizontal as you move to the right from a given initial point:

The Keynesian aggregate supply curve shows that the AS curve is significantly horizontal implying that the firm will supply whatever amount of goods is demanded at a particular price level during an economic depression. The idea behind that is because there is unemployment, firms can readily obtain as much labour as they want at that current wage and production can increase without any additional costs (e.g. machines are idle which can simply be turned on). Firms' average costs of production therefore are assumed not to change as their output level changes.

In other words, he is assuming that costs of production are the only determinant of price, from the point of view of the supplier. This is true very often, because due to competition, suppliers have to keep down their price to costs of production plus some standard mark up, because that's what the competition is doing. 

In other words, prices are rock bottom already, and will stay the same until costs of production go up. And costs go up mainly because of higher wages, which will go up only when there is full employment. Until then people will accept the going wage rather than be unemployed.

Wiki continues:

This provides a rationale for Keynesians' support for government intervention. The total output of an economy can decline without the price level declining.

The Austrian take on all this? That there is a little boo-boo in that picture, mainly that it assumes costs of production will stay constant as supply goes down. But that isn't so. If supply is less, then, at the same price, less money is coming in for everyone, the supplier as well as the provider of his resources. This will put pressure on costs of production to go down.

Keynesians are no fools. They know this, and their rejoinder is that the biggest cost of production is wages. And wages don't go down, ever. Wikipedia mentions this:

This provides a rationale for Keynesians' support for government intervention. The total output of an economy can decline without the price level declining; this fact, in conjunction with the Keynesian belief of wages being inflexible downwards, clarifies the need for government stimulus.

The Austrian rejoinder? Yes, if wages are inflexible downward, and won't go down when they have to, we are in a pickle and will have chronic unemployment. For sure. But what makes wages inflexible downward? One thing. Govt intervention. Long story why.

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Albert replied on Wed, Apr 24 2013 11:59 AM

OK Dustin, which point of view do you want to discuss?

  1. From mainstream economic arguments like your instructor?
  2. From the Austrian point of view?
  3. How it works in real life?

1. Your instructor probably has some Keynesian indoctrination. Therefore they believe the resession was brought on by a change in public attitude that leads to lower spending that leads to unemployment. They think the whole economy has only one demand curve like he described. They believe it is the governments duty to goad these unemployed to fill the demand to stop it from moving to the right to avoid the vertical line. They incorrectly assume because they are only looking at one Wholistic economy that those unemployed are interchangable. The truth is there are many supply and demand curves going on at the same time. Some are totally collapsed like the mortgage industry from the real estate boom, some are shifted to the left, like fewer contractors and furniture stores are needed because fewer people are buying homes. These are mostly the source of the recent unemployed. Some are steadily moving to the right because peoples priorities have changed and there is a shortage of qualified suppliers - I can't think of a good example but lets say that private colleges are experiencing a boom because all these unemployed are getting re educated in new fields. It is not possible for the newly unemployed mortgage broker or contractor to just get a job at Rasmussen college and start teaching accounting or tax preparation or just jump in and be absorbed by the health industry for example. There is an immediate result that affects some of us immediately and there is a lag period before it is obvious to the rest.. on some of these demand curves like the stock market, food and oil, inflation has already shown, in others it might take a while, its just hard to see if you only look at the aggregate economy.---- but if you want to pass your course you just better give him the answers he wants.

2. You know the Austrians don't define inflation as "rising prices"

We say that inflation started THE MINUTE  the government increased the money supply like drug lords supplying an addict. It benefits the first receivers, banks, and their friends first before it is obvious to us that prices are rising. Then the next level of recipients still benefit because they have cash and only slightly higher prices. (They are whomever the banks spend their money on- maybe like crony capitalists in phony industries like Solyndra ) By the time this trickles down to Joe Public the prices will have risen tremendously. There is a "lag period" that is dependant on who gets the money first and where they spend it to make prices go up in those sectors first, before it trickles down to the regular consumer prices the public scrutinizes. Also the government is still continually increasing the money supply by $50B per month to hide the symptoms) It has nothing to do with "depression economics" or 100% employment or unemplyment resources being idle.

3. In real life inflation is happening regardless of what your instructor is showing you on his demand curve. You just cannot believe the " official number" published by the powers that be. That number is a lie, they have multiple ways to juggle it and they use strange formulas that exclude food and gas for example. If you check the real prices of services and products now compared to 2003 you will find multiple examples of 30% to 100% increases.

Does that help?

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Neodoxy replied on Wed, Apr 24 2013 12:12 PM

As I argued very ardently in my "The Broken Window and the Recession" thread, if prices are inflexible and aggregate demand falls then government spending and increases in aggregate demand will not result in increasing prices and crowding out of private investment.

The problem with this worldview is that it views the economy holistically. In reality there are varying levels of employment from industry to industry. Because the government doesn't control where money goes, the increase in demand may or may not result in a proportional increase in output, decrease in unemployment, or change in the "price level" (which doesn't actually exist). It depends on the exact circumstances and the actual microeconomic repercussions of the macroeconomic policy.

Implicitly, however, it's not at all unrealistic to think that an increasie in the money supply will cause a lower rate of inflation when a larger number productive inputs are idle

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As I argued very ardently in my "The Broken Window and the Recession" thread, if prices are inflexible and aggregate demand falls then government spending and increases in aggregate demand will not result in increasing prices and crowding out of private investment.

As luck would have it, I just finished an humble article about why there will be crowding out:

https://smilingdavesblog.wordpress.com/2013/04/24/smiling-dave-takes-on-nobel-prize-winner-vickrey-third-topic-do-deficits-crowd-out-anyone/

and

https://smilingdavesblog.wordpress.com/2013/04/23/after-explaining-vickreys-second-fallacy-at-length-smiling-dave-is-ready-to-respond/

My humble blog

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Dave,

While as always I have some complaints with your article, you do hit on a lot of good points. I just want to say that you don't show that in the absence of flexible prices that government spending will cause crowding out (I'm increasingly certain that this would invalidate the laws of supply and demand), you show that prices are in the process of "stretching" and that the government interrupts this process. Indeed, one could argue that this causes 'long term crowding out", which is an interesting concept I've never seen argued, although it doesn't follow the normal crowding out narrative. While the point about price adjustment is an important point, and it's probably the most important point, but it doesn't make the point about price flexibility any more untrue.

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Neo,

Thank you for the kind words.

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Bogart replied on Wed, Apr 24 2013 11:54 PM

It does matter that the argument of price increases or decreases is arguing over symptoms of inflation and not arguing about the effects of inflation itself.  By far the worst effect of inflation is to provide incorrect signals to entrepreneurs about the availability of real savings.  Entrepreneurs perform Economic Calculation using the availability of savings to predict future profitability.  The failure of these entrepreneurs will inevitably lead to a crash.  Entrepreneurs perform distorted economic calcuation without price increases leading to failures.  Actually price increases ARE POSITIVE as they signal to the central bank/central price fixer that they have increase the artificial price of saving to mitigate the negative effects of an impending crash. 

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In real life, there are several ways additional liquidity can be "buffered" before it causes a substantial increase in the price level of the items used to track inflation.

People may be hoarding cash for instance.

But there might be resources that were idle before and now are trading because of the excess liquidity. 

Say liquidity is injected in the form of low interest rates. An employer facing low interest rates calculates that he has more room for business, so he hires more people, reducing unemployment.

These newly employed people might not start consuming like crazy right away, they might hoard some cash for a while, or more likely, pay debts before they are able to increase consumption on the items that display inflation.

And thats the "stage one" effect.

How long does the stage one effect lasts before stage two of price level inflation kicks in? It varies a lot.

It depends on depth of the capital reserves that are being depleted to keep pumping the monetary gas inside the economic engine, and that's hard to estimate.

 

Austrians believe that you cannot escape the negative consequences of capital depletion, and that your liquidity injection will cause a more severe recession in the future. Since new capital is being added but there's no savings, it must be coming from a restructuring of existing capital, and this might cause some problems in the future, when we find out what parts of the capital structure were being neggleted.

Other schools believe that some undesirable positive feedback loops that appear in a depressed economy might be very well averted by the cash injection. For instance, people that are long term unemployed tend to develop self-defeating habits and if you can find artificial ways to get them some action they might eventually become productive assets. And if that happens before the undesirable complications of monetary inflation start creeping in, they might be eased to some extent or even avoided.

 

I think both scenarios are possible and both happen simultaneously in different parts of the economic system. But overall I think it's wrong to think in terms of what happens to "society as a whole", instead of identifying "qui bono" given the particular circumstances of each situation. I think this collectivist tendency is s a cognitive bias that affects most schools of economic thought. But it's particularly pernicious to austrians since they self-describe as "methodological individualists". 

"Blood alone moves the wheels of history" - Dwight Schrute
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Thanks for the responses. I need time to digest all the responses here. There is a little more than I was expecting (not a bad thing).

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