Inflation and Monetary Policy. Thought of the Day 89.0

The traditional economics believes that there exists an output-inflation tradeoff in the short term, which means that it is impossible that both higher economic growth and low inflation can be attained at the same time. Policymakers may either increase the money supply to promote output but it will also push up inflation, or be reluctant to choose a recession to reduce inflation if they are faced with inflation problem.

However, traditional economists also consider that output-inflation tradeoff does not exist in the long term since average inflation has no effect on average output. In order to bridge the contradiction between the two output-inflation relations, the dynamic-inconsistency theory has been proposed and developed that describes that the public’s knowledge of policymakers’ discretion will make policymakers deviate from their policy so that a low-inflation monetary policy may cause inflation without any increase in output, and thus the output-inflation tradeoff will vanish in the long run.

Unfortunately, the dynamic-inconsistency theory can hardly predict actual inflation and account for the time-series variation in inflation so that the invalidity of it may be attributed to a belief on the part of policymakers that there might be a long-run output-inflation tradeoff. The problem of how output-inflation tradeoff can lead to inflation has so far been confusing and controversial.

In the framework of this dynamic quantity theory of exchange, there is no concept of the output-inflation tradeoff whether in the short run or in the long run. The economic situation of low inflation and at the same time high output growth is an ordinary economic operation form as stagflation where high inflation and low output growth occur simultaneously does. A low-inflation policy can lead to higher inflation through three ways. The economy may arrive in high inflation with small or large change in real output through the direct RNC (Relative Natural Cycle) process if money growth slowly increases or declines, namely through Greater Inflation or Lesser Inflation behavior of economy.

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The hypothesis of driving cycle with the GI (Greater Inflation) and GO (Greater Output)

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The hypothesis of driving cycle with the LI and LO

The economy can also experience a DR (Double Rise) process when money growth is evidently increases and then do a NC (Natural cycle) due to production atrophy to attain the high inflation region. The economy is certainly likely to reach high inflation only along the balanced path where money growth rate is constant. We can observe that a low-inflation policy may eventually result in inflation because of changes in money growth or production atrophy, and thus it does not need to use the output-inflation tradeoff theory and dynamic-inconsistency theory to explain.

According to the dynamic quantity theory, it is not necessary that the policymakers make a choice between low inflation and high economic growth. The policymakers only need to maintain the stability of monetary growth so that the economy can run in the natural cycle where economic crisis characterized by the DD (Double Drop) may be avoided. It is to be noted that the driving cycle includes two types of operation mode, one is called as relative natural cycle (RNC) which shows there is still an inverse relationship between inflation and real output growth for small changes in money growth, relating to the four behaviors, greater inflation (GI), greater output (GO), less inflation (LI), and less output (LO), respectively; and the other is called as strong driving cycle (SDC) which indicates a positive relationship between inflation and real output growth for large changes in money growth, expressed by the double drop behavior (DD) and the double rise behavior (DR). In addition, there are two behaviors, stagflation and golden growth, in the natural cycle.

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The policymakers may of course take an accelerated monetary policy for the economy to go into the Double Rise channel, but once the economy is not able to have greater growth, the economy will inevitably be slipping to stagflation. Moreover, the inflation is caused only by the accelerated monetary growth or the decelerated output growth in this framework and accelerated output growth resulting from financial incentive policy never induces inflation. This could be a long-term misunderstanding of economic growth and inflation.