Thursday, December 11, 2014

Inflation is information theory not ethical philiosophy

Scott Sumner argues that there has been both zero inflation and that 100% of NGDP growth was inflation (both since 1964). Tyler Cowen makes a good point about these arguments changing with income. However, Sumner's main conclusion is that inflation is a pointless concept -- in terms of understanding macroeconomic systems.

I think the real answer here is that economists don't really know what inflation is and they fall back on 19th century concepts like utility to ground them. Cowen and Sumner both ask if you'd rather live in 1964 or 2014 with a given nominal income. If that's what defines inflation -- hedonic adjustments and utility -- then I'd totally agree with Sumner: that's pointless.

But it is in this arena that the information transfer model may provide its most important insight (regardless of whether you picture money as transferring information from demand to supply or from the future to the present). The idea is spread over two posts, with the second being the main result:
  1. What is inflation?
  2. Expectations (rational or otherwise) and information loss
When money (M) is added to an economy, that means more information is being moved around. The difference between how much more information could theoretically be moved around with that money (proportional to M^k) and how much more information is empirically observed to be moved around (proportional to measured NGDP) is inflation.

Inflation has nothing to do with the specific goods and services being sold at a given time. It doesn't matter whether it's an iPhone or a fancy dinner. It doesn't matter whether it's toilet paper or bacon. Inflation is an information theoretical concept, not a philosophical utilitarian one.

2 comments:

  1. I can't tell if you're claiming that "inflation" can have multiple meanings, one of which is related to actual vs. potential information movement, or if you're claiming that "what it costs now vs. what it cost back then" is somehow a meaningless concept. Can you elaborate?

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    Replies
    1. I think "multiple meanings" is the best answer. One meaning, in terms of information, is based on a simpler, more concrete model than the other meaning, in terms of changing prices for the same goods, which is more model dependent (including substitution effects and hedonic adjustments).

      There is a third meaning in terms of preferences over baskets of goods (would you choose 1964 over 2014 with the same nominal income) that I think is pretty meaningless, though. Modeling inflation for a loaf of bread, approximately unchanged from 1964 to 2014, is probably tractable (that's the second meaning above). Attempting to account for the existence of iPhones in 2014 (but not in 1964) gets a bit too philosophical for a concrete analysis. When you start to compare whether an iPhone is worth more or less than the ability to see the Beatles in concert you get to what Scott Sumner was saying about the pointlessness of inflation.

      But I don't think this third utilitarian (preference) view of inflation is a well-defined concept like the first two (information theory and price changes) -- and the first two meanings actually seem to coincide empirically!

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