I got in an argument with an anonymous commenter on my previous post as is my wont. He (it is probably a he) made the claim that post-WWII inflation was due to relaxing price controls and had nothing to do with my information equilibrium monetary model where the lack of Fed independence and interest rate pegging (and the failure of the general equilibrium solution [GE] to fit the data) meant we might want to apply the accelerating inflation solution [AI]. The lack of Fed independence lasts from 1942 to 1951 (until the Treasury-Fed accord), therefore the AI solution should be restricted in scope to that time period. Before and after that time, the GE solutions apply (see here).
Note that the AI solution doesn't mean inflation is high, it just means that monetary expansion becomes more and more inflationary as time goes on. If you keep monetary expansion at 5%, inflation might be 5% one year, 10% the next, and 20% the next. However, you could keep inflation at 5% over the entire time by reducing the monetary expansion -- e.g. from 5% to 2.5% to 1.25%.
The price control model (the commenter refuses to believe it is a model) would apply from when the price controls went into place in 1943 to 1946 (per this paper by Paul Evans), with a model-dependent burst of inflation afterwards (1946-1948).
What is interesting is that you can see the impact of price controls on the AI solution:
The AI solution seems to be valid from 1942 until the 1960s (at which point the GE solution that I usually show takes over). From 1943 to 1946, price level growth is about half what you'd expect from the AI solution of the information equilibrium model. When the controls turn off, you get a rise back up to where you'd expect from the AI solution. You can see this is a perturbation (a small model effect) to the accelerating inflation (hyperinflation) information equilibrium model (which covers a much longer period).
The deficit of inflation (red) is made up (blue) when the price controls are removed. Now I'd say that the accelerating inflation model "explains" WWII and post-WWII inflation -- the only way you can understand the price level effect is with a model for where the price level should be in the absence of price controls. Price controls themselves are only a small part of the story. In fact, without some underlying model, you have no idea how big the price control effects are. Here, we can say inflation is about half what it would be while the price controls are in effect and about three times higher after you turn them off. Without that, you have no way of knowing when one theory applies or how much of what we observe is explained by which theory.
Economists (and my anonymous commenter) tend to treat the model above as two separate models, when in fact they can both be active at the same time. Dani Rodrik would say there is a theory for when the price controls are in effect and one when they're not. But what we really have is one theory that is in scope for the entire domain, and a second perturbation for when there are price controls.
" The price control model (the commenter refuses to believe it is a model) would apply from when the price controls went into place in 1943 to 1946 (per this paper by Paul Evans), with a model-dependent burst of inflation afterwards (1946-1948)."
ReplyDeleteYou have it bad.
You can't see reality as reality.
The Government says no price increases or else.
What's there to model?
What's the price burst post control relaxation got to do with interest rate pegging? The pegging of the treasury rate went on for another year.
Can you imagine the pent up pressures and demand after 4 years of control?
I'm not supporting Evan's model or not.
What I am making a point about is that you witness a correlation between interest rate pegging and a burst of inflation and bingo you have a theory about how to restart inflation and save the world from deflation.
Your Anonymous Commenter (YAC)
"The Government says no price increases or else."
DeleteBut prices increased during 1943 to 1946. There is about 2-3% inflation during that period. Prices increase that much today without price controls. Therefore you must have some sort of model to extract why inflation should have been higher (shortages due to the war effort, or in my case, monetary expansion).
"What I am making a point about is that you witness a correlation between interest rate pegging and a burst of inflation and bingo you have a theory about how to restart inflation and save the world from deflation."
No, I saw a correlation between interest rate pegging and selecting the accelerating inflation solution of the differential equation:
dNGDP/NGDP = k dM0/M0
I'm pretty sure governments can engineer a hyperinflation without my help -- q.v. Venezuela.
"The pegging of the treasury rate went on for another year."
The three-month secondary market rate went up, but the long term interest rates continued to be capped at 2.5%. Regardless, it's not that the pegging causes the accelerating inflation solution -- it's that pegging sets you on the accelerating inflation solution.
Initial conditions can determine the behavior of a differential equation solution -- for an example in economics, there are the saddle path and the divergent paths of the RCK model.
"What's the price burst post control relaxation got to do with interest rate pegging? "
ReplyDeleteI see no response.
To keep the rate fixed the Fed had to buy every treasury bond thrown at it, pumping money into the economy which was then recycled into government coffers, thru bond sales, to support the war effort, then spent by the government. When the price controls ended and rate pegging continued what would you expect to happen?
And I remind you of what you said in your previous blog:
"It's the pegged interest rates (or exchange rates) that appear to be key to hyperinflation, not monetary base (MB) growth, printing money (M0) or deficits themselves."
Yacky
"What's the price burst post control relaxation got to do with interest rate pegging? "
DeleteI see no response.
I think you just don't get the response. The interest rate peg sets the economy on the hyperinflation/accelerating inflation solution (as I mention above).
Pegged interest rates are the key to selecting that solution. Before I noticed that was no other indicator for when you should select it besides working empirically. But selecting models ex post given data is a terrible methodology. Something should tell you which model (or in this case, which solution to the differential equation) to use.
"Therefore you must have some sort of model to extract why inflation should have been higher ........ or in my case, monetary expansion)."
DeleteIs this not in contradiction to your prior statement:
"It's the pegged interest rates (or exchange rates) that appear to be key to hyperinflation, not monetary base (MB) growth, printing money (M0) or deficits themselves."
No.
DeleteThere are two possible universes (solutions to the differential equation); call them AI and GE. In both cases, M0 growth (monetary expansion) leads to inflation. In order to extract what inflation would otherwise have been, you need either AI or GE to determine counterfactual paths of inflation given counterfactual paths of M0.
Pegged interest rates appears to choose AI over GE. Non-pegged interest rates appears to choose GE over AI.
It is the key to hyperinflation in the way that a car key is a key to the car. You don't need to keep using the key in order to accelerate. You turn the key and now you're in the "car running" universe (solution).
A more accurate car analogy would be that GE represents 1st gear and AI represents 2nd gear. Pegged interest rates choose 2nd gear. However, the accelerator (monetary expansion) operates in both 1st and 2nd gear -- the gears just change the relationship between RPM (gas pedal) and velocity.
Mathematically, we have two possibilities:
DeleteP1 = AI(M0)
P2 = GE(M0)
Pegged interest rates select P1 or P2, but both P = f(M0), so M0 → M0 + dM means that P → P + dP.
I have a question: should Japan consider a currency peg (temporarily) to ignite a high level of inflation currently?
ReplyDeleteHi Todd,
DeleteAs I've said before, I am not sure generating higher inflation is necessarily a worthwhile policy goal.
Also, a currency peg seemed to have no effect in Switzerland -- so it's not just a peg maintained by OMOs, but some kind of other way. I'm not familiar enough with different ways of maintaining a currency peg to suggest that route.
I mentioned the currency peg because of Venezuela because interest rates didn't seem to be pegged. However, it could be that Venezuela is just printing that much money and has that much government spending funded by it that it ended up with high inflation.
Dunno, but seems to me throughout history the best way to get rid of government debt seems to be via inflation (U.K. early 19th century, U.S., U.K. after WWII etc.). May not necessarily help Japan's quality of life, but would make it easier to reduce the debt. But your point is taken: printing (cash) money should also do the trick, and also provide fiscal stimulus, provided it's not abused.
Delete