Why nominal changes have real effects

In an economy using pens as currency, the expected growth rate of pens is what's important

Matt Ygelsias does a good job explaining in pretty simple terms why some recent evidence suggests that the cause of the current crisis is the fall in aggregate demand:

If low aggregate demand is at the root of our problems, then we should be able to solve our problem through helicopter drops. Mail envelops full of dollar bills to each American household, and spending will increase. The increased spending will induce firms to increase the pace of activity, which will lead to more hiring, more real output, and a virtuous circle of higher incomes and higher demand. But… [w]on’t that just lead to ruinous inflation?

The answer is that, yes, most of the time printing money and mailing it to people would merely lead to inflation and not do anything to boost real output. To get more real output you need more workers, or more productive workers, or better regulations, or something. You can’t just have more spending.

Back to [these results, which found that] there’s no correlation between [inflation expectations and the stock market]. Which is exactly what you would expect to find in a scenario where you can’t boost growth just by printing money. But then comes the crash of 2008, the 2009 recovery recovery, the mini-crash of 2010, and the renewed recovery an extended period of time when inflation expectations and real growth expectations are tightly correlated. That means that the very same swings in nominal spending that push inflation up or down are also—and simultaneously—pushing real output up and down. That indicates that any measures we take to increase nominal spending, up to and including mailing envelops of newly printed dollars to random households, will mobilize idle resources and increase real economic output.

But what he doesn’t explain here is why now is especially different. And obviously, there are different interpretations explaining why printing money now is useful. But I think there are two relatively simple ideas here:

1. The way people make decisions depends on their knowledge of the present and their predictions about the future. When they’re planning, they’re hoping for some relatively stable things, and one of the most crucial is future income. They think about this mostly in nominal terms, that is, the actual dollar amount they’re going to receive this month and the next. As Scott Sumner has been pointing out, nominal growth was kept at a steady 5% clip year in and year out, a number which US businesses implicitly or explicitly counted on when making their decisions. In the early part of the crisis, however, the Fed, for fear of inflation, allowed the nominal growth of the economy not just to dip below 5% but actually to go negative — thereby throwing into disarray all of these plans dependent on the assumed rate of growth. In this situation of inherent uncertainty and mismanaged capital (because of the false assumptions about nominal growth), businesses had to lay off hundreds of thousands of people and redirect resources to conserving themselves rather than making risky investments. And in this environment, any change in nominal GDP towards the 5% people had been predicting made these past decisions dependent on that nominal growth better decisions, and so actually worked to improve not just nominal but real growth.

2. The actual way this process of printing money and improving real growth works is in the way Yglesias describes: resources, like unemployed people or unused factores, which are now not producing goods because of these flawed predictions, can be employed using this pick-up money. And because there was a shortfall in predicted nominal GDP, this should not lead to huge amounts of inflation. Russ Roberts is worried that this idea that printing money can lead to improvements in the economy is flawed because using this logic Zimbabwe, which had absurd hyperinflation, should be thriving. But this is not the right way to think about it. Zimbabwe, to my knowledge, did not inflate their currency to meet nominal predictions about growth, but rather to pay off their debts, as well as “increasing” salaries of government employees. Thus, instead of working to maintain current monetary conditions, they essentially printed money to make people happy in the short run. But the responsible way to make monetary policy work is to allow people to be relatively confident in nominal growth staying around the same year after year.

Think about it this way. If everyone used pens to trade for things — I could give you ten pens and you’d give me a book, or 500 pens for a computer — and then suddenly something which everyone assumed was worth a large number of pens fell to be worth a much smaller amount of pens — say, real estate — then the number of theoretical pens in play would fall sharply. In this situation no “real” wealth was destroyed — all the houses are the same, people are just not as willing to give as many pens for them. However, because of this nominal change fewer pens are moving around the economy, being transferred and thereby fueling wealth-creation. In this situation we would want the government to step in and just hand out some pens, to make up for the ones we thought we had but didn’t because expectations are what’s important.

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One Response to Why nominal changes have real effects

  1. Pingback: House price growth.. | The Grand Glenprop Blog

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