Saturday, January 5, 2013

The Mechanics of Cost-Push

You think you can show that printing money causes inflation with a graph like Milton Friedman's MRTO: Compare the ratio "M2 money relative to Real Output" to the trend of prices. I think you're wrong.

Spending is the process by which demand pulls prices up. But the money we spend is not measured by M2. M1 includes funds that are readily accessible for spending.

And "real output" is a useful number. But you can't divide something by real output and compare the result to inflation, because real output is already corrected for inflation. Dividing by real output skews the result to look like inflation. It fakes the result.

Consider instead the quantity of spending-money, relative to the purchase-price of output. Now, if there is 40 cents of money per dollar's worth of output, or 20 cents, or 10 cents, the relation to inflationary pressures is obvious. 40 cents may be "too much money chasing too few goods." 20 cents may be just right. 10 cents may be so little that it leads to financial crisis.

Graph #1: The Mechanics of Cost-Push
The blue-and-red line on the graph shows my version of "money relative to output": the quantity of money in the spending stream, relative to output at actual prices. The blue line shows the years 1915-1970. The red line shows the years 1959-2010.

The gold line shows the annual rate of inflation. But I have scaled the numbers down and shifted them up a bit, to get a good fit between the gold line and the blue.

The green line uses Moody's AAA bond yield for the rate of interest. Again I scaled the numbers down and shifted them up, this time for a good fit of the green line to the gold.

Before the early 1960s we had demand-pull inflation. The upper limit on inflation was set by money chasing goods. But in the years since, inflation has been more closely related to interest rates.

If I said to you that the latter half of the graph shows interest rates themselves a major cost-push force, you would counter by saying but interest rates move in response to inflation. So instead let me say that both those things are true, after about 1960.

In the earlier years, however, different forces were clearly at work.

Related post: The Suppression of Money

Related Google Docs spreadsheet: The Suppression of Money

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