Wednesday, October 26, 2005

Monetarism and Me

Steve D asks about the exact meaning of the term "monetarism" in a comment to a previous post.
Steve's Comment: "Forgive me, for my knowledge of the issue is scanty and even that is fleeing quickly, but isn't one tenet of monetarism a slow expansion of the money supply that will ultimately result in some residual inflation? I think that having 2% inflation is less dangerous than having no inflation at all, because at zero inflation you are straddling that line into deflation, which must be avoided at all costs. But like I said, it's definitely not mu strongest subject, and so my interpretation may be way off."
We're not a real economist, but we play one on this blog. We don't believe that monetarism per se implies a desire for some level of inflation. Monetarism does emphasize the "supply" of money as a key determinant of inflation and deflation, as opposed to "excess" or "too little" demand for goods (Keynesian view).

An expanding economy, in the monetarist view, has the capacity to absorb additional money without generating inflation. A contracting economy needs more money injected to ward off deflation. Economic growth and increased productivity without monetary expansion will gradually reduce the general price level over time. This means that the money supply can be gradually expanded (to a certain extent) without generating inflation.

Since the Great Depression, American economic policy has been driven by the fear of that memory. Generals often try to "fight the last war" even as the situation changes. Absolute price stability is not achievable (perhaps not even definable), but a long term average of 0% inflation is desirable from any point in time. Having a 1-2% fall in the CPI in a given year is not necessarily a bad thing.

Why is "low" inflation a problem? Even a 2% inflation rate means that most savers are not earning any real return after taxes and inflation. It means that borrowers are gaining at the expense of lenders, encouraging borrowing and discouraging saving. It means that everyone's taxes are going up in our "progressive" tax system, and that government is automatically confiscating a greater share of the national wealth each year. It triggers automatic increases in many government spending programs. It builds in an expectation of future inflation in everyone, helping it become a self-fulfilling prophesy. At a 2% annual inflation rate money loses half its value in 36 years. At 3% it takes just 24 years for your money to lose half its value.

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