From: bucknerb@bnr.ca (Brent Buckner)
Subject: Re: It's not a Depression because prices aren't falling?
Organization: Bell-Northern Research, Ontario, Canada
Distribution: usa
Date: Mon, 17 Aug 1992 16:59:13 GMT

In article <seX8v_600awBAeOEV1@andrew.cmu.edu> Thomas Omar Smith <ts2a+@andrew.cmu.edu> writes:
>david@mail.sas.upenn.edu (R. David Murray) says:
>>My grasp of monetary theory is weak, to say the least, but I thought
>>I understood that cutting interest rates as the Fed has been doing
>>was an inflationary action.  I was puzzled, then, that the 'inflation
>>rate' is so low.  Then it occured to me: in the Depression, we were on
>>a hard money standard, and so prices fell.  Now, we are on a fiat
>>standard.  So suppose real prices are actually falling so rapidly that
>>the fairly significant inflation of the money supply being practiced
>>by the Fed can just barely keep up?
>
>Well, I'll agree your grasp is weak.  But it does appear to be a lack of
>education and not a lack of logic.  Let me try and enlighten you a bit. 
>Your mistake is that you assume that the fed changing interest rates
>occurs as a reaction to inflation.  

As I read it, R. David Murray was referring to the expected results
of the Fed action, not the motives for the Fed action.

>In fact, the fed is probably not
>worrying a whole lot about inflation right now.  What the fed is
>concerned about is the fact that spending is way down.  The theory is
>that if interest rates are sufficiently low, people will be inclined to
>borrow money and take advantage of the low rates.  This increases
>spending and pulls us out of the recession.  It is of limited value in
>reality, although it is a good theory.  
>	When inflation is high, interest rates tend to rise since future risk
>is higher.  

Are you refering to long- or short-term rates, and are they real
or nominal?  The Fed has a large amount of influence over short-term
and less over long-term rates (in that long-term rates reflect the
market's predictions of the Fed's future behavior, not the Fed's
present behavior itself).

>However, inflation is inversely guided by velocity, which is
>a function of spending.  

Not according to Fischer's Identity.  If you up the velocity,
leave the number of transactions and the money supply the same,
the only way that those dollars could be moving around
faster is if the transactions are occuring at higher dollar
amounts.  The price level varies directly with velocity.

>Therefore, inflation usually occurs when
>spending exceeds what the money supply can handle.  More and more
>currency becomes necessary for transactions, and inflation results. 

Here you are claiming that inflation results from an increase in
the money supply, not a change in velocity.

>Lowering rates then may help pull down inflation, or it may help inflate
>the spending trends and make the situation worse.  

By what mechanism would lowering rates decrease inflation?

               [deleted]
>Also, it is important to note that despite its best
>efforts, the fed has not been able to increase the money supply by much,
>so that should tell you that your theory is incorrect.

Not to my view.  Over the last year, the Fed has increased M1 (the physical 
supply of dollars) by 11.78%.  M3 has increased by .02%. 
We don't know what would have happened if the Fed had not increased
M1.  For example, if M1 had stayed flat,
M3 may have declined by 11.76%; there may have been deflation.

With respect to real prices, the CPI has increased by 3.2% over the
past year.  If you choose M1 as your (measure of) money supply, then real
prices are down 8.58%.  If you choose M3, then real prices are up 3.18%.
M3 is traditionally regarded as a better measure of the money supply.

You can have deflation without real prices declining (aside:  just
as you can have inflation without real prices increasing).  I suppose
that if the Fed hadn't increased M1, we would have seen exactly that.
-- 
at Bell-Northern Research
voice:        (613) 765-2739
Canada Post:  P.O. Box 3511, Station C, Ottawa, Canada, K1Y 4H7
I do not claim that BNR holds these views.  
Newsgroups: sci.econ