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Saturday, April 22, 2006

Are Unemployment and Capacity Utilization Measures Irrelevant for Monetary Policy?

John Tamny writing in the NRO Online says:

...inflation is a monetary phenomenon that occurs exclusive of economic growth...

This is wrong. When money grows at the rate of economic growth, all else equal, it is not inflationary. The reason is simple. Money is needed for transactions. As the economy grows, we buy more stuff so we demand more money. Supplying money to meet that extra demand is not inflationary - the money supply can grow at the rate of output growth without inflation. See Nouriel Roubini and David Backus and their derivation of the equation (inflation = money growth - output growth) and discussion of Friedman's money growth rule for more. It is true that an increase in money growth increases inflation one to one if output growth is unaffected and I think this is what Tamny has in mind. But as Roubini and Backus note:

As Milton Friedman put it: "Inflation is always and everywhere a monetary phenomena." It's only after you think about that sentence for a while that you realize it's not as informative as it first sounds.

I don't particularly care for Tamny's analysis either where it is argued that globalization makes measures of capacity utilization and unemployment irrelevant for monetary policy decisions. The article does not distinguish between excess domestic capacity, e.g. restarting an existing factory in the U.S., and building a new factory in in the U.S. or a foreign country. In one case, production can be brought online fairly quickly, in the other there are substantial time lags. There is really no thought given to concepts of the short, medium, and long run and how that might differentially affect inflationary pressures, e.g.:

Domestically, it has to be remembered that as opposed to being static, capacity is ever changing. Be it through the expansion of existing plants, the introduction of robotics, or innovation that expands output from existing facilities, capacity is a fluid concept that should not be measured in terms of the here and now. ...

Regarding capacity utilization and assumptions about U.S. companies reaching arbitrary limits, it should be remembered that ... U.S. companies ... access the world for capacity, making any domestic capacity measures irrelevant.

When there is excess demand and there is no excess capacity remaining, the fact that factories can be built, expanded, or modernized either in the U.S. or in foreign countries does not mean there will be no upward pressure on prices in the interim and the Fed needs to account for this as it sets policy.

If there is instantly accessible excess world capacity, it would be true that excess demand would not be inflationary, but that isn't the case. There aren't modern but idle factories in China and India or other countries that can be opened instantly once firms serving U.S. markets begin to affected by capacity constraints. It takes time to move or start production offshore and in the meantime, excess demand will be reconciled by rising prices. Even if there are idle foreign factories, supply chains to the U.S. are not as easy to restart as for domestic firms with excess capacity. So, while unskilled labor is abundant in the world:

Indeed, with the continued penetration of 100 million-plus workers from the former Soviet Union, China, and India into the labor force, the notion of coming labor shortages seems pretty farfetched. ... The developed economies of the world will surely access these additions to the labor force, making the point about tight labor markets in any one part of the world moot.

Just having lots of labor isn't enough. Labor must have the proper skills for the particular production activity undertaken and the factories, management, etc. all have to planned and put into place before production is possible. In the meantime, prices must rise to temper excess demand.

It may be true that the long-run response of the world economy to excess demand is faster than it once was due to globalization and that may affect the degree to which the Fed will want to tighten to avoid inflation as measured by a standard medium run target. But adjustment is by no means instantaneous - it still takes substantial time to alter the global mix of production. Thus, even with globalization, inflation can arise in response to excess demand in the short and medium runs as the global economy responds to the demand shock, and measures of domestic capacity utilization and unemployment remain important signals for monetary policy makers regarding the existence of potential inflationary pressures.

    Posted by on Saturday, April 22, 2006 at 01:52 PM in Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (24)


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