If you write a blog you obviously want people to read what you write and even better you want to inspire discussion. I was therefore very happy when Duncan Brown sent me his two latest blog posts, which both are inspired by stuff I have written.
Duncan’s posts are very interesting. The first post – Shocking supply and volatile demand – uses a (crude) method I developed to decompose demand and supply inflation. Duncan utilizes this method – Quasi-Real Price Index – on UK data. The second post – In the 1950s, Rab Butler sets an NGDPLPT mandate… - also uses one of my ideas and that is to look a what inflation historical would have been had the central bank had an NGDP target. Duncan looks at the UK, while I earlier have looked at the US.
A Quasi-Real Price Index for the UK
I first time suggested that inflation could be decompose between supply and demand shocks with what I inspired by the brilliant David Eagle termed a Quasi-Real Price Index in a blog post in December 2011.
This is from my 2011 post – A method to decompose supply and demand inflation:
David Eagle in a number of his papers on Quasi-Real Indexing starts out with the equation of exchange:
Eagle rewrites this to what he calls a simple equation of exchange:
(2) N=P*Y where N=M*V
This can be rewritten to
(3) Shows that consumer prices (P) are determined by the relationship between nominal GDP (N), which is determined by monetary policy (M*V) and by supply factors (Y, real GDP).
We can rewrite as growth rates:
Where p is US headline inflation, n is nominal GDP growth and y is real GDP growth.
Introducing supply shocks
If we assume that we can separate underlining trend growth in y from supply shocks then we can rewrite (4):
Where yp is the permanent growth in productivity and yt is transitory (shocks) changes in productivity.
Defining demand and supply inflation
We can then use (5) to define demand inflation pd:
(6) pd=n- yp
And supply inflation, ps, can then be defined as
(7) ps=p-pd (so p= ps+pd)
Duncan uses this method on UK data and I must say that his results are vey interesting.
Here is a graph from Duncan’s post on the decomposing of UK inflation.
Based on his results he concludes:
“Policy may have looked loose in terms of interest rates, but relative to context, this was one of the most extreme tightenings on record. The implication is that while we’re always going to be prey to supply shocks which will create some volatility in output and employment, we need to be careful to allow demand to grow in a predictable, sustainable way. The trouble with an inflation target is that the nightmare combination of an adverse supply shock and a damaging tightening of monetary conditions looks – as it did at the time – like things are on track. Policy should aim to stabilise demand inflation, even as supply inflation moves around; it is a pity that the mandate most likely to be able to achieve this result (a nominal output level path) has been ruled out by the Treasury.”
As a Market Monetarist it is hard to disagree with Duncan’s statement. However, it should certainly also be noted that Duncan’s results give reason to think that the nature of the present crisis in the UK economy to some extent is different from the crisis in the US or the euro zone economies. Hence, it seems like the present subdued growth in the UK economy to a larger extent than is the case in the US or the euro zone (overall) is due to supply side problems (Weak demand is the primary problem, but supply issues seem more important than in the US). In that sense the UK economy might share some similarities with the Icelandic economy. See my earlier post here on why the Geyser crisis to a large extent was caused by an supply shock rather and a demand shock.
A counterfactual inflation story for the UK
In his second post Duncan tells the counterfactual story of what inflation would have been in the UK since the 1950s if the Bank of England had been targeting an 5% NGDP growth path. The method is similar to the one I used in my post The counterfactual US inflation history – the case of NGDP targeting.
You can see Duncan’s counterfactual inflation data in this graph.
Duncan’s results for the UK are rather similar to the result I got for the US. However, it seems that UK inflation under NGDP targeting than would have been in the case in the US in recent years. That do indicate that that the low growth in the UK economy to a larger extent than is the case in US. That, however, also mean you need lower demand inflation to achieve the Bank of England’s present 2% inflation target.
It is not all I agree with in Duncan’s two post – for example I think he misinterprets his results to mean that the primary shocks to the UK economy has been supply, while I think his results in fact shows that demand shocks have been the primary driver of the UK business cycle – but I would nonetheless recommend to all of my readers to have a look at Duncan’s blog. It’s good wonkery.