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That 1970s inflation

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Patrick Horan directed me to these tweets: Luther is right.  There are actually three issues that need to be disentangled here: 1.  The cost of high trend inflation 2.  The cost of high inflation volatility 3.  Supply vs. demand-side inflation High trend inflation increases the real tax rate on saving and investment, which hurts capital formation.  This reduces economic growth, lowering living standards. The negative effects are not offset by gains to borrowers, as the Fisher effect implies that nominal interest rates rise to reflect higher inflation expectations. As Appelbaum suggests, an unexpected surge in inflation can indeed help borrowers.  However, in the long run there will be just as many years where inflation is less than expected as there are years

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Patrick Horan directed me to these tweets:

That 1970s inflation

Luther is right.  There are actually three issues that need to be disentangled here:

1.  The cost of high trend inflation

2.  The cost of high inflation volatility

3.  Supply vs. demand-side inflation

High trend inflation increases the real tax rate on saving and investment, which hurts capital formation.  This reduces economic growth, lowering living standards. The negative effects are not offset by gains to borrowers, as the Fisher effect implies that nominal interest rates rise to reflect higher inflation expectations.

As Appelbaum suggests, an unexpected surge in inflation can indeed help borrowers.  However, in the long run there will be just as many years where inflation is less than expected as there are years where it is higher than expected.  The gains to borrowers in the 1970s were offsets by losses in the 1980s, when inflation fell more rapidly than expected.  Hence lots of loan defaults and a big S&L crisis during the 1980s, followed by an expensive taxpayer bailout.  The 1970s were the party; the 1980s were the hangover.  There’s no long run gain to borrowers from a policy of higher inflation.  (Not to mention that there’s no plausible reason why we’d want public policy to favor borrowers.)

A high level of inflation volatility (as we saw during 1966-81) tends to create business cycles.  (Actually, it is NGDP growth volatility that matters, but that was also very high during the 1970s.)  Because of the highly unstable monetary policy, the US experienced four recessions between 1970 and 1981, and two were quite severe.  The high inflation did not help workers.

Nonetheless, there is a reasonable case to be made for the argument that the 1970s inflation was not as bad as it seemed.  The US was hit by two supply shocks (1973-74 and 1979-80), which resulted in real wages falling during those two spikes in inflation. In both cases, the fall in real wages wasn’t actually caused by the inflation; it was caused by a real shock to the economy, less energy to drive our economy.  Those two shocks would have hurt living standards even if the Fed had kept inflation at low levels.

On the other hand, NGDP growth was very higher during the 1970s (roughly 11% from 1971-81) and hence the 8% inflation was not caused by supply side factors. (Real growth was a bit over 3%/year.) Rather the long run inflation was almost 100% demand side.  Don’t confuse temporary supply shocks that affect the volatility of inflation with long run demand policy that determines the trend rate of inflation.  If NGDP growth had averaged 5% during 1971-81, then inflation would have averaged 2% (or even less if the counterfactual monetary policy had boosted capital formation.)  Inflation shocks affect the volatility of real output, without boosting the long run trend rate of growth.

Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment". In May 2012, Chicago Fed President Charles L. Evans became the first sitting member of the Federal Open Market Committee (FOMC) to endorse the idea.

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