## Sunday, August 4, 2013

### One could argue that growth is the cause of inflation ...

... but there would be better things to do with your time, unless you were trying to show just how really bad a certain sort of evidence can be.

I think many bits of parody and wit get lost online.

Like Newton inventing gravity, let us invent the notion that there is a cost associated with growth. Imagine that we can state this cost as a number and that we can work with it as others might work with, say, "Unit Labor Cost" data. We can call our number "Unit Growth Cost".

We can even model our new data series after the Unit Labor Cost series. Their source data is "total labor cost" data. Our source data should be something associated with economic growth. I think the most legitimate, well-respected data we could use is the GDP data itself.

Since we are most concerned with the cost of growth, we want to choose the variant of GDP that best expresses the cost involved. That variant would be actual (or "nominal") GDP, which measures the actual cost to purchase output.

So we have our numerator. As for the denominator, we would want to use the same valuable divisor that is used for the Unit Labor Cost calculation: inflation-adjusted (or "real") GDP.

Before we proceed, let's stop and review some of the other causes of inflation besides growth, and the evidence that has been put forth for those causes. There is of course the problem of labor, and the Unit Labor Cost evidence:

 Graph #1: The GDP Deflator (red) as a Measure of Prices, and Unit Labor Cost (blue)

It is easy to see the similarity between the two lines. The red line is prices. The blue line is the labor cost measure. They are strikingly similar, unbelievably similar. So labor cost must be the source of inflation.

Unbelievably similar, and unbelievably significant. Matthew Yglesias says "my favorite indicator of inflation is 'unit labor costs'" (via SRW). Cullen Roche says "there is a very high correlation between inflation and labor costs in the USA... Higher labor costs coincide with higher wages." The Revision Guru says "Changes in unit labour costs (ulc's) are important in determining the underlying rate of inflation..."

But there is another cause of inflation, better known even than unit labor cost. It is Milton Friedman's "money relative to output" which we can show in a FRED graph:

 Graph #2: The GDP Deflator (red) as a Measure of Prices, and the Quantity of Money Relative to Output
Again it is easy to see the similarity between the two lines. Friedman even points out that "there is nothing in the arithmetic that requires the two lines to be the same"

But the lines certainly are similar!

Now, to our superlative measure, the one that shows that growth is the true cause of inflation. Our measure is the blue line on Graph #3. Our calculation is actual GDP as a percent of output. The red line is prices:
 Graph #3: The GDP Deflator (red) as a Measure of Prices, and GDP per unit of Output
Oh my God! This is an exact match! Friedman's graph was good, and the Unit Labor Cost graph was good, but this graph is spectacular! See how closely our blue line tracks the red "prices" line! This is unbelievable!

Perhaps we have discovered something here today.

Related post: These are the relations...
Also: Here's another formula you can rearrange...

Anonymous said...

I hope I am stating the obvious when I say (GDP/GDPC1)*100 is the definition of GDPDEF.

May have to re-read the post because I'm not seeing what has been discovered.

Anonymous said...

I agree with the above.

I think the logic here is circular. Real GDP is computed by adjusting nominal GDP for measured inflation. So solving for that inflation via these two indices is not deriving inflation.

I think what you meant to do is to derive a relationship from the Change in Nominal GDP. That would be interesting to see but I don't think it would be useful.

The Arthurian said...

Read the first sentence like it was part of the title, and read the next bit -- the quote about parody and wit.

My point is not that (GDP/GDPC1)*100 is a great explanation of the cause of inflation.

My point is that "Unit Labor Cost" and "Money Relative to Output" are no better than my "Unit Growth Cost" as a way to explain the source of inflation. The three are equally and similarly flawed.

My arguments are pathetic: "let us invent the notion" that we want to prove... I claim to use GDP because it is "the most legitimate, well-respected data we could use" ... and I choose a denominator because it is "valuable". (Source of confusion: Lots of serious economic arguments are equally pathetic, I'd say.)

But perhaps, sadly, the "discovery" is that my wit is not so good as I thought.

The Arthurian said...

"There is of course the problem of labor," I wrote. And of Graph #1 I said the two lines "are strikingly similar, unbelievably similar. So labor cost must be the source of inflation."

No one objects to that ?

I do.