If your central bank crushes income growth…….

It is a self evident fact, given that wages are sticky, that if the sum of total income falls, unemployment must rise. What is less evident, but nonetheless true, is that Nominal GDP is tautologically equivalent to the sum of nominal incomes. What almost no one believes, but is true, is that the central bank has complete control of where it wishes to send nominal variables. Since it controls the price of money, it can always devalue money sufficiently to make it sensible to employ people again. Hurrah!

Some people believe that lowering the price of money is synonymous with inflation, but this is not the case. I lot of people envision inflation along the following lines: there is a stock of real goods, and a stock of money, and if the money supply increases faster than the stock of real goods, then we have inflation. This is an insufficient conception of inflation, in particular, this would mean that high fiscal multipliers would render money printing deflationary! Why? Because a high multiplier means that one dollar printed and spent generates more than one dollar in extra output.

To successfully conceptualise inflation, we must concentrate on money spent. If multipliers are high, then each dollar printed generates multiple extra dollars of demand, and multiple extra dollars in output. In an ideal world this would hold inflation at zero until output approached potential output, at which point extra stimulus will generate purely inflation and no extra real output. In the real world, we get some split between extra output and higher prices. At the moment in a depressed economy like Europe that split favours real output, as we approach full employment/supply side constraints, the split moves towards more inflation and less output.

The critical point is then twofold: in the current environment, monetary stimulus will not lead to inflation in the Eurozone. The second point is that we are in a severely disinflationary environment. Any time NGDP moves below trend, that is the definition of disinflation. Definitions of inflation based around the final prices of goods are a hostage to fortune, since it allows supply side shocks to prices to morph into demand side shocks. The costs of weak demand are immense, as years worth of output goes unused. The costs of supply side shocks which are correctly managed, is a slight one off rise in the price level.

Here is the unemployment graph for selected european countries, so we can all meditate on the ongoing human tradgedy, which is the cost of poor ECB policy:

Credit to SocGen via Alphaville for this one

And lets not forget that the forecast for improvement two years from now is simply the obligatory european forecasting tool of assuming that two years from now things will get better for no clearly specified reason except the general disbelief that they cannot get any worse. In 2010 the EU was predicting spain’s unemployment would peak in 2011 at 20%. That didn’t exactly go according to plan…

 

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About worldofinterest

I know I live in my own world, but I like it: they know me here.

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