Inflation is a game of cat and mouse

I have been reading David Romer’s class notes called Short-run fluctuations. Part of his paper deals with a model to explain inflation in a liquidity trap. The model is based on real interest rates, output, expected inflation, Keynesian cross and IS-MP model stuff.

He writes… “An economy where the nominal interest rate is zero poses severe challenges for policymakers. If output is less than its natural rate, inflation will tend to fall. With the nominal interest rate stuck at zero, this will raise the real interest rate, and so depress the output further. Policymakers therefore face the risk of the economy spiraling off on a path of continually falling inflation and output, like what we just analyzed.”

I don’t see output falling like he describes. and How does he determine output’s natural rate? Does he use effective demand? His approach seems like the tail wagging the dog.  I mean… I don’t think he is seeing the root mechanism of inflation. I don’t like his explanation. So what does determine inflation?

Most have heard the standard definition of inflation… Too many dollars chasing too few goods. Let’s start here.

This definition comes specifically from demand-pull inflation, but is used for inflation in general.

Now imagine a cat chasing a mouse. If the cat is powerful, nimble and quick, the mouse will be caught. Now imagine dollars that are powerful, nimble and quick. Those dollars will catch the goods. Let’s say the dollars are so powerful, nimble and quick that even if you raised the price of the goods, the dollars can still catch them. You now have inflation.

Now imagine goods chasing dollars. That’s right, goods now have the power, nimbleness and quickness to chase dollars. Goods are now the cat. But would this scenario lead to inflation? No… This scenario would lead in the opposite direction… to low inflation. The goods have the power to keep their prices low by way of luring and baiting the weak dollars into their trap. Goods have become the predator upon dollars and are optimizing their profits.

Dollars are the money spent by consumers. Goods are the production of firms. The relative prowess between the two determines where inflation will go.

If the liquidity of consumer dollars is more powerful, nimble and quick then the capacity of firms to manage production, you will have inflation. Dollars will compete for the products, which in turn raises prices. On the other hand, if firms are powerful, nimble and quick in managing their suppliers, production and distribution (like wal-mart), then prices will be kept low, along with wages. Goods will have the power to compete with each other for consumer dollars at low prices.

(note: I have not shopped at a wal-mart in over 12 years. One reason for the decline in the US economy is the increased prowess of firms to prey upon the wealth of our middle class, while paying low wages to the poor class.)

Ok back to the subject of inflation… We can create an equation to simulate where inflation will go…

Inflation tendency = liquidity prowess of consumer dollars/production prowess of firms

  • If the numerator and denominator are equal, then inflation will be constant and most likely move to exactly where the Fed wants inflation to be. (Inflation tendency = 1)
  • If liquidity power of consumers is stronger, then inflation will tend to rise. The Fed will battle inflation, for example Volcker.  (Inflation tendency > 1)
  • If production prowess of firms is stronger, then inflation will tend to go lower. The Fed’s job in battling inflation is made easier. (Inflation tendency < 1)

But let’s look at cases when the liquidity prowess of consumer dollars is stronger.

  • Higher wages (higher labor share) relative to production capacity in the 1960’s and 1970’s led to episodes of inflation.
  • At the LRAS curve where we find the natural level of output, firms are constrained to produce more while labor increases its consumption dollars. Inflation tends to spike upward at the LRAS curve.

Let’s look at cases when the production prowess of firms is stronger.

  • Period from 1990 until the present. Real income has been lagging behind productivity. Labor share has been declining. This has given the edge to firms to be more nimble than consumers. Inflation has been trending lower over that whole time.
  • The period following an economic contraction. Firms control production and the utilization of labor. Unemployment is up and wage growth is slow, while firms are re-employing their factors of production. Inflation is low during this time.

It should be no mystery at the present moment why inflation is tracking low. Inflation tendency from the above equation would be less than 1. Firms have high profits, developed infrastructure, and access to capital. Consumers have low labor share of income and higher than normal unemployment. Total labor income is barely back to where it was before the crisis, while capital income has increased beyond that point. Firms are the current predator.

If the Fed truly wants inflation, the Fed will find a transmission mechanism to increase the prowess of labor’s liquidity in relation to the firms’ prowess to produce. But I don’t think that is likely, because the Fed seems to be working for firms and not consumers. The Fed and the firms it represents prefer low inflation, but they have gone too far.

We have had too much supply-side economics. Firms have become cats to all of us consumer mice.

David Romer has the wrong liquidity trap theory for low inflation. Inflation is low not because of the ZLB liquidity trap, but because the weak liquidity of consumers is falling into the trap set by the powerful, nimble and quick firms.


Related articles:

Effective demand model for monetary policy. Shows that low labor share is the cause of the persistent ZLB status of the Fed rate that David Romer says is the cause of low inflation.

Post on low inflation. Shows a more detailed approach to explaining low inflation.