Toward a New Macroeconomics, Part Two

The creation/destruction matrix tells us about employment. What about inflation?

In my view, there is no reliable Phillips Curve. Also, the behavior of velocity means that the monetary authority cannot precisely control inflation (or nominal GDP). Instead, there are three regimes for inflation.

1. Anchored expectations. People expect inflation to be low. When the central bank alters the money supply, velocity tends to move in an equal and opposite direction.

2. Hyperinflation. The fiscal deficit is out of control. Government spending far exceeds what the government is able to take in through taxes and borrowing. Money is printed at an ever-accelerating rate, and its velocity rises as households and businesses try to minimize their losses from holding money. The private sector becomes reluctant to use money at all, and its use becomes increasingly confined to transactions with the government.

3. Inflation fever. As in the U.S. in 1970-1985, inflation reaches a level where it becomes a major factor in the financial planning of households and businesses. They put cost-of-living escalators into contracts. They adopt financial innovations that allow them to minimize holdings of non-interest-bearing money, creating upward lurches in the velocity of money. This behavior in turn reinforces inflation, producing a vicious cycle of high and variable inflation.

In terms of the monetarist equation, MV = PY, I view velocity has highly unstable. When inflation expectations are anchored, monetary policy is ineffective because of offsetting movements in velocity. Under hyperinflation, there is no independent monetary policy–money is printed to fund the government debt. When there is inflation fever, velocity is high and variable, and the monetary authorities can do little about this. In the early 1980s, perhaps Paul Volcker was able to turn things around. Or perhaps the bond market vigilantes, by raising long term real interest rates, boosted the value of the dollar and brought down oil prices, thereby breaking the inflation fever.

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4 Responses to Toward a New Macroeconomics, Part Two

  1. Bret says:

    How often has 2 happened in a country that had no debt OTHER than in its own fiat currency?

  2. Maximum Liberty says:


    So your view of the central bank as such is that the best that they can hope to achieve is achieving and staying in a regime of anchored expectation? Put another way, what you equivocally ascribe to Volcker is moving from the third regime to the first?

    In the concept of anchored expectations, do you account for any effect for a central bank that predictably and consistently (over long periods) changes money supply in response to inflation that varies from a target? (I’m not saying that’s the case anywhere; nor am I saying that inflation is a good target. I’m just trying to understand the implications of what you are saying.)


    • Arnold Kling says:

      I think that if inflation expectations are anchored, the central bank does not have to consistently change the money supply in response to inflation If money growth were slow for some reason, then velocity would speed up, and vice-versa.

  3. Michael says:

    I like the emphasis you put on expectations. I think that partly explains why inflation has remained largely on target despite the massive expansion of the Fed’s balance sheet.

    However, on this comment:

    “the behavior of velocity means that the monetary authority cannot precisely control inflation (or nominal GDP)”

    This may be true, but I don’t think precise control of inflation or nominal GDP is needed – I think imprecise management of inflation or nominal GDP expectations is what is important for monetery policy.

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