A Paradox of Expected Inflation

In yesterday’s post about the effects of QE2, I discussed the tendency of an increase in expected  inflation to cause the prices of real assets, including the prices of commodities, to increase.  That is, if we expect prices to rise in the future, we will choose to reallocate our asset holdings, exchanging cash for physical assets, driving up the prices of those assets in the process.  So the expectation of increased inflation occasioned last year by the announcement of QE2 undoubtedly was one factor in causing the subsequent run-up in commodity prices, expectations of accelerating economic growth and negative supply shocks being two others.

However, the rise in commodities prices triggered by an increase in expected inflation is not the same as an increase in inflation.  Rather it is a once-and-for all adjustment in the relative values of physical assets and money associated with the inflation-induced shift in desired asset holdings.  If inflation stabilizes at the newly expected rate, commodities prices will not continue to rise faster than the rate of inflation (for purposes of this exercise I am assuming that inflation is uniform across all good and services).  But this also means that measured inflation will tend to overshoot the new higher expected steady-state rate of inflation.  I note again that other factors probably contributed to the temporary spike in inflation, but increased inflation expectations, in and of themselves, tend to cause a transitional measured rate of inflation above the new expected rate.

The distinction between steady-state inflation on the one hand and a once-and-for-all increase in prices (apart from the expected increase in inflation) on the other may clarify one of the most puzzling (for me at any rate) passages in the General Theory (p. 142) in which Keynes criticizes Fisher’s distinction between the real and nominal rates of interest.  After observing that an expected reduction (increase) in the value of money would tend to raise (depress) the marginal efficiency of capital curve, Keynes goes on to make the following comment on Fisher:

This is the truth which lies behind Professor Irving Fisher’s theory of what he originally called “Appreciation and Interest” – the distinction between the money rate of interest and the real rate of interest where the latter is equal to the former after correction for changes in the value of money.  It is difficult to make sense of this theory as stated, because it is not clear whether the change in the value of money is or is not assumed to be foreseen.  [The latter comment is itself a curious statement by Keynes inasmuch as Fisher was totally explicit in basing the distinction on foreseen changes in the value of money.]  There is no escape from the dilemma that, if it is not foreseen, there will be no effect on current affairs; whilst if it is foreseen, the prices of existing goods will be forthwith so adjusted that the advantages of holding money and of holding goods are again equalised, and it will be too late for holders of money to gain or to suffer a change in the rate of interest which will offset the prospective change during the period of the loan in the value of the money lent. 

Keynes, referring to changes in the value of money, seems to have had in mind a once-and-for-all change in the price level rather than a change in the rate of change in the price level (i.e. a change in the rate of inflation).  Fisher, however, when discussing the distinction between the real and the nominal rates of interest, was clearly analyzing changes in the rate of inflation .  There is a lot more to be said about Keynes’s views on the effect of inflation (or changes in the price level) on the rate of interest and other macroeconomic variables, but this simple point may help to achieve some sort of reconciliation between Fisher’s and Keynes’s views on the rate of interest.  Allyn Cottrell wrote a very interesting paper on the subject many years ago.  A couple of years ago this subject came up on Scott Sumner’s blog, and Kevin Donoghue was helpful to me in understanding what Keynes was saying.  By the way I seem to recall that in the Treatise on Money, Keynes accepted Fisher’s distinction without quibble.  If Kevin is out there and would care to weigh in on the subject, I would be glad to hear from him.


12 Responses to “A Paradox of Expected Inflation”

  1. 1 Benjamin Cole October 17, 2011 at 7:52 pm

    In today’s global economy (and a world of speculative commodities markets), I sense that too much attention is being paid to commodities.

    1. The USA (like Japan) might do whatever to its money supply, but in a world of 3 billion Chindians consuming more goods…..we can choke ourselves but watch oil go higher, just like the Japanese.

    2. The NYMEX and Brent OIl markets are not exactly transparent. Also, (unlike stocks) it is perfectly legal for a Goldman Sachs to issue stories or plant stories and take positions (on behalf of clients) in the NYMEX. It is legal to cloak identities of ultimate cleints. Large fractions of tarding ahve been controlled by allied entities. Additionally, you have large sovereign nations that export oil as their lifeblood—it would be patriotic for Putin to try to rig the NYMEX from time to time.
    So, influential speculators drive oil prices higher, and we put a monetary noose around our necks? That makes sense?

    3. George Gilder pointed out that commodities booms are necessary to bring about fresh supplies and conservation.

    4. I suspect healthy economies in today’s world will result in commodities booms for a decade or two, given the vast scale of economic development in Asia. We can choose the alternative (and we are): Unhealthy economies.

    5. Gold is on the moon, and indicates little but the emergence of a Chindian middle-class that buys gold. Most gold is sold there. We choke ourselves to stop Chindians from buying gold?

    My advice to Market Monetarists and everyone else: Forget about commodities, forget about gold. Pay attention to economic growth, prosperity and innovation.


  2. 2 Kevin Donoghue October 18, 2011 at 6:59 am

    I am indeed out here and glad to know that I was of assistance. I read the Cottrell paper (Keynes and the Keynesians on the Fisher Effect) at your suggestion and I agree it’s very good. Sadly there doesn’t seem to be freebie version online. Beyond that I don’t have much to add. I suppose the change in Keynes’s line on this, between the Treatise to the GT, is due to the fact that in the Treatise he hadn’t got to grips with involuntary unemployment. In the GT there is an optimal (real) interest rate which will generate full employment, but not much reason to suppose that the market will settle there. So at that point in the GT we’re left with just an IS curve.

    BTW you lost a bit of Keynes’s text; it should read: “There is no escape from the dilemma that, if it is not foreseen, there will be no effect on current affairs; whilst, if it is foreseen, the prices of existing goods….”


  3. 3 David Glasner October 18, 2011 at 7:31 am

    Benjamin, I agree there is no reason to hyperventilate about commodities prices. But if the critics of QE are using rising commodities prices to discredit QE, we can’t just ignore them. And you are right to observe, as did Marcus Nunes, that global growth is going to force up the real value of commodities whatever our monetary policy is.

    Kevin, Thanks for flagging the missing text. What do you think about my distinction between the expected steady rate of inflation and an expected change in the price level in the context of Keynes’s discussion of Fisher?


  4. 4 Kevin Donoghue October 18, 2011 at 10:48 am

    David, you’re probably right; Keynes is mostly concerned with whether news of a future step-change in the price level will promote production of capital goods. Most likely he is thinking of the case where expected inflation is near-zero both before and after. But it’s easy to apply his reasoning to an economy with steady inflation where there is a jump in the expected rate of inflation. Although I’ve no evidence that he thought about that, his argument still works. There will be a jump in demand for many goods: anything worth storing, basically. At the other extreme are markets for fish and haircuts (with acknowledgements to Dennis Robertson and Nick Rowe). Eventually we get to a new steady-state where the real interest rate and relative prices are all back at their equilibrium levels. But as usual it’s the transition that interests Keynes.


  5. 5 JP Koning October 18, 2011 at 11:37 am

    Hi David, just a few definitional questions.

    “…I discussed the tendency of an increase in expected inflation to cause the prices of real assets, including the prices of commodities, to increase…”

    What do you mean by “real asset”? Or alternatively, what are these non-real assets that do not benefit from expected inflation?

    “…if we expect prices to rise in the future, we will choose to reallocate our asset holdings, exchanging cash for physical assets, driving up the prices of those assets in the process. ”

    What do you mean by physical assets? What are the non-physical assets that do not get exchanged for cash?


  6. 6 Scott Sumner October 18, 2011 at 7:23 pm

    David, My views on this haven’t changed since my earlier post. Keynes was operating in a gold standard world where almost all inflation and deflation was unforecastable–the price level was approximately a random walk. In that world there is no Fisher effect. I think Keynes conceded at some point that a Fisher effect could occur with the high inflation then associated with fiat regimes (recall that in the 1920s people associated fiat money with hyperinflation.)

    The other point is that the prices that matter in the Fisher effect are the prices of assets like commodities and real estate, not things like haircuts. And it is the asset prices that are the most flexible. So Keynes was right that if they were expected to change, they’d tend to change right away.

    I searched long and hard and was unable to find a single Keynes comment on what things would be like if you had a positive but low trend rate of inflation. Nothing. I don’t know if he ever considered it.


  7. 7 David Pearson October 21, 2011 at 3:57 pm

    Market prices discount future trajectories of growth. The question is not whether China real growth was strong in 2011, but whether it was “stronger than expected” by commodities markets. I have yet to see proponents of the “real China growth drives oil and ag prices” thesis explain why those markets failed to anticipate that growth. IEA data shows that China oil imports grew at a 4% rate in the first three quarters of 2011. Are you saying markets expected that growth to be below 4%, and were so surprised by the 4% figure (as it developed) that they bid up oil prices (Brent) by 40% since Jackson Hole?


  8. 8 David Glasner October 22, 2011 at 10:12 pm

    Kevin, A lot of commodities, especially, but not only agricultural commodities, have high storage costs. So for those commodities, expected inflation will only cause their prices to increase instantaneously by a fraction of the expected increase. Similarly for assets that provide a current flow real services, expected inflation can’t cause the current price to increase by the full amount of expected inflation. So perhaps, that complication allows some room for accommodating the Fisher effect without rejecting Keynes’s insight.

    JP, A non-real asset is a claim to a fixed sum of money, typically a bond or a mortgage or cash. Real assets are assets that embody or are claims to a flow of future services. So a real asset could be a consumer durable or a house or a claim to the future profits of a business.

    The difference between a real asset and a physical asset is that a real asset could include claims to physical assets rather than the physical assets themselves. Does that help?

    Scott, Why do you say that the prices that matter for the Fisher effect are the prices of assets but not the prices of services? Are you suggesting that the only reason that Keynes criticized Fisher in the GT was because Keynes was assuming that the price level would only change in the short run (in an unpredictable fashion as it did under the gold standard) but would be stable in the long run? That doesn’t seem to correspond to Keynes’s criticism on p. 142 where Keynes explicitly rejects Fisher’s reasoning in the case of expected inflation.

    David, There is some tendency for commodity prices to change immediately in response to changes in expected inflation, but if the expected inflation is correctly anticipated, I think that there would be a continuing upward drift in commodity prices for reasons that i mentioned in my response to Kevin’s comment.


  9. 9 JP Koning October 24, 2011 at 2:03 pm

    Hi David, I think I am having problems understanding your article because you include so many categories (thank you for explaining what you mean by real and non-real assets). You also talk about commodities, goods, and services. What is the difference between a good and a physical asset, for instance? This mulitplicity of categories makes it difficult for me to understand what you mean by inflation, since the “composite commodity” that you create to measure purchasing power could include (or not include) all of the different categories you have created (real assets, commodities, physical assets, goods, services). Not sure which of these goes into the basket you use to define inflation.


  10. 10 David Glasner October 25, 2011 at 7:51 am

    JP, A good is any tangible item that people value. However, it may be used up (consumed) in the course of being used, e.g., food. A physical asset is something that remains in existence over time, though not necessarily indefinitely, e.g., a car. In principle, inflation measures the changes in the prices of all goods and services. Assigning weights to all the items in the basket is a tricky problem, so tricky that I think it is impossible to solve, but we can still arrive at useful approximations.


  11. 11 JP Koning October 26, 2011 at 11:01 am

    David, feel free to give up on me for being pedantic, but… it seems to me that all goods must be physical assets. As you say, a physical asset is something that remains in existence over time. But in order to be consumed, a good has to be capable of remaining in existence for some period of time. How else would you get it from the store shelf to the kitchen to your stomach? So a good is also a physical asset.

    So if we expect prices to rise in the future, we will exchange cash for physical assets, a category that includes goods, driving up the prices of those assets in the process.


  1. 1 My Paper (co-authored with Paul Zimmerman) on Hayek and Sraffa « Uneasy Money Trackback on February 20, 2013 at 9:17 pm

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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