Letters from my Macro professor

[Virgil0211]

I recently started a dialogue with my macro-economics professor, and I thought I would share it with you guys. For the sake of privacy, I'll leave out the names and simply color-code the dialogue (Blue for mine, Brown for my econ professor).

I was curious about the term 'inflation'. I was doing some reading on the internet, and some appeared to be using the term inflation primarily to refer to a decrease in the value of money itself, or sometimes an increase in the supply of money, rather than raising prices. I was wondering if this was also correct, related to a particular school of economics, just a matter of semantics, etc.

An excellent questions.

Technically, an increase in price(s) may not be "inflation". One classic example is an increase in oil/gasoline prices. No one would claim than the increase in energy price two years ago was due to inflation, yet some argue that policy should change to eliminate this rise in price.

Short answer (which you have already figured out): The definition has changed over the years and/or means different things to different people (in particular schools of thought).

Hope this helps. If not ask again later when we get to the money and inflation chapter. For now, inflation is a rise in prices.


Thank you for your answer. I meant to ask about it earlier when we reviewed the 'principles of economics', particularly when the discussion about modifying the money supply came up. As far as I remember it (and this may be influenced by my own exposure), you used the analogy of an island where a box of money was dropped on it without a corresponding increase in production/consumption. It made me think of the two economic schools I'm primarily familiar with, the monetarist/Chicago and Austrian (I'm a libertarian, what can I say?). From what I understand, that example falls in line with the Chicago school's stance on monetary policy, making small increases in the money supply that would correspond with increased production. However, the Austrian perspective, from what I understand, is rather opposed to the idea of increasing the general supply of money.

However, the possibility strikes me that this may be an error on my part, confusing different aspects of conditional positions concerning monetary policy. The Chicago stance I described above was in reference to fiat currency. The Austrian school seems to dislike fiat currency in favor of currency issued based on single commodity standards (I say 'single commodity' to distinguish from 'mixed commodity'), precious metal standards such as gold, silver, and platinum in particular. The anti-inflation (Austrian sense) stance of the Austrian school may have more to do with the condition of a fiat currency, seeing as how the 'Austrians' I speak to typically argue either in favor of said commodity standards and/or market currencies.

I guess this isn't so much a question as it is an observation I would like to hear your comments on.


I think you understand the Austrian view correctly. There are a few corrections/additions that I would add: The Monetarist school (and Austrians) believe that changes in monetary policy can influence real output temporarily; in the long run money is useless in promoting standards of living. The temporary increase in output is due to different circumstances (compared to the Keynesian school and their description of the effects of monetary policy).

Where they differ is that the Austrians (as you noted) tend to be very "hawkish" on inflation, hence the reliance on a commodity standard. The monetarists tend to be "O.K." with fiat money (or even prefer it to a commodity money), they are against discretionary monetary policy. Instead, they tend to favor clear, well developed rules to govern changes in monetary policy.

Personally, I tend to believe certain insights of both schools and that they have much to contribute to macroeconomics.

I have seen the video. There is an interview with Russ Roberts (the co-creator) on the web, where he discuss the video's production (no economic theory discussed). If you are interested in the link let me know.


Thank you for your reply. I guess my remaining question comes back to your example of the island where the currency is dropped in. If the currency was a commodity standard, like gold, how would it change to fit the increased production/consumption? Does deflation become a problem under a commodity standard?

So, what's the Keynesian school's stance on inflation? What I know of Keynesian theory primarily has to do with the ability of the government to promote growth via public works and other government spending. That, and irrational market behavior/the animal spirits.

Also, where does Bernanke fit as far as economic schools are concerned? Most of the things I hear about him from my Austrian friends are primarily frustrated lamentations of his fiscal policy combined with a comment concerning his diet, which may or may not include live neonatal homo-sapiens.

The "helicopter drop of money" as a thought experiment is valid under a fiat system and also under a commodity system. Under the fiat system, the amount drop can be any amount desired. Under a commodity system, the amount is based on the amount of the underlying commodity that is "created". You can have "large" inflation under a commodity standard. Read about the cyanide process to extract gold and its effect on prices in the late 19th century. Yes, deflation can exist under a commodity standard (again look at the period prior to the late 19th century), but deflation isn't, necessarily, a problem.

The Keynes question is a hard one (in my opinion), because Keynes tended to say one thing, then change his mind later. The Keynesian school does focus mostly on private household saving and firm spending (investment), government spending, and the business cycle. Keynes thought that interest rates should be kept low to increase investment. If monetary policy was a means to accomplish this goal, then increase the money supply as needed. Keynes' world was one of "sticky" prices and wages (i.e. slow to adjust). In this type of world, government action could eliminate the business cycle, if needed (if low interest rates failed to keep the economy from thriving). Some say, that according to the Keynesians, "money does not matter [for inflation]". I am not sure if this is quite true. Certainly under conditions of sticky prices, more money will not drive prices higher.

Bernanke? I have no idea. He is either a monetarist, a New Keynesians (another school of thought), or a hybrid of the two. Austrians tend to dislike the Fed (I know you are shocked by this), and their scorn is usually placed on the head of the Fed, no matter who the head is. The Fed controls the monetary policy only; they have no control over fiscal policy. They can give an opinion, but fiscal policy is strictly under the auspices of Congress. Bernanke's family is Jewish. I don't know if he is a practicing Jew, but they strictly forbid the consumption of children for nutritive purposes (i.e. not Kosher). In fact, in the Bible, the Jews preached against sacrificing and eating children. So, I am pretty sure on this point - he does not each children.

I see. So the Austrian preference for a commodity standard is due to the difficulty in inflating the currency and its relative stability compared to a fiat currency?

Also, I was curious as to where the value of a fiat currency comes from. I understand that the government essentially declares the currency to have value (by 'fiat') and that it is to be accepted for transactions and the payment of debts. I guess it's mainly some confusion. I asked this question to another friend of mine who I think is more a monetarist than an Austrian, and he described the currency's source of value to be 'confidence in the United States government'. However, I can't help but think of the fiat currency as something akin to Chuck-E-Cheese tokens or prize tickets at an arcade, where the value would be determined by how high a demand the products (prizes) you could purchase with the tokens/tickets. So, is a fiat currency given value by confidence in the government, or interest in the country's commerce?

I guess it makes sense that the Austrian school would be at odds with the Keynesian school. The Austrians say that artificially low interest rates lead to malinvestment (if that's actually a real term for it. The spell checker underlines it as misspelled.), whereas the Keynesian school prefers to keep interest rates low to increase investment, right?

Is there a way to objectively measure the 'stickiness' of wages and prices, or are there just too many variables you would have to control for to make an accurate measurement?

I've also heard a couple of things from one of my more eccentric friends about the Phillips curve. He's the only one I've heard this from, so I can't exactly say whether this is related to the Austrian school or not, but he describes it as being useless in the long term and potentially useless in the short term because it made 'selective observations'. I'd have to press him for more details, but I was curious if this was related to an actual debate in economics.

Well, most of my Austrian friends only complain of Bernanke when discussing monetary policy anyway. For the rest of it, they usually blame congress. I'll put it this way- if Bernanke eats children, then congress eats orphans and puppies. Or they just plain 'eat'. (Sorry. I inherited my grandfather's tendency to make bad puns.)

So, what's the difference between the Keynesians and the New Keynesians?

Thoughts/comments?

[MrBogosity]

Sounds like a pretty good professor to me.