The Quantity Theory of Money and the Fisher Effect

The Federal Reserve primarily adjusts the United States’ money supply by selling or purchasing government securities, such as treasury bills or bonds.  The Fed increases the money supply by purchasing securities from large banks and dealers, thus increasing the total amount of money in the economy.  Likewise, the Fed decreases the money supply by selling their share of government securities, taking money out of the economy.  According to the quantity theory of money, adjusting the money supply directly affects price levels in the long run.

The quantity equation states:

where

The velocity of money measures the rate at which money circulates in the economy.  Economists assume V is fixed, since people’s cash holding preference is relatively constant (the bar above V denotes that it is a fixed variable).  Output can be affected by interest rates in the short run according to the IS-LM Model, but Y is a function of labor and capital in the long run, so it is also fixed in this theory.  The above equation shows that if the Federal Reserve changes the money supply, price levels must adjust to maintain equilibrium.  So if M increases, P must increase, and if M decreases, P must decrease:

Since money supply has a direct effect on price levels, the central banks have ultimate control over whether or not their country experiences inflation.  The quantity equation highlights the direct relationship between changes in money supply and changes in price levels in an economy.  The Fisher Effect explains the direct relationship between changes in price levels and nominal interest rates.  The Fisher Equation states:

i = r + π

where

i = Nominal Interest Rates, r = Real Interest Rates, and π = Inflation Rate

This equation is intuitive since it simply states that the nominal interest rate is equal to the real interest rate plus the inflation rate.  However, the Fisher Effect shows an important one-to-one relationship between the inflation rate and the nominal interest rate once r is made constant, since real interest rates adjust to achieve equilibrium between savings and investment in the long run.  Graphing the inflation rate and nominal interest rate for the US over the past 46 years shows the strong correlation between these two variables:

The quantity theory of money shows that a percent change in money supply is met with an equal percent change in price levels, and the Fisher effect shows that a percent change in price levels causes an equal percent change in nominal interest rates.  It is important to note that these theories hold true for the economy in the long run, and may not be useful for short run economic analysis.

Chained CPI and Social Security Benefits

President Obama proposed his budget for the US Government on April 10^th, which attempts to close the budget deficit over the next ten years.  This article from The Economist shows where the cuts from the budget would come from.   Notably, Obama proposes a $230 billion cut on Social Security spending, a policy opposed by many Democrats.  Social Security benefits are adjusted each year based on a Cost of Living Adjustment (COLA), which is calculated with the CPI-U so that social security recipients have the same purchasing power from year to year.  As mentioned in my article on CPI, the CPI-U is a measure of inflation that is determined by monitoring price levels of a fixed basket of goods purchased by the average urban consumer.  Obama’s budget proposal would change COLA from being calculated with CPI-U to C-CPI-U.

C-CPI-U is the chained consumer price index of urban consumers.  Since one possible cause of inaccuracies with the CPI-U is that it does not account for substitution, the C-CPI-U attempts to compensate for this by using a variable basket of goods.  A variable basket of goods assumes that when price levels rise on a particular good, consumers substitute that good for a different, similar one.  Inflation measured by the chained consumer price index for urban consumers is on average 0.3 percentage points lower than the CPI-U.  This decrease in measured inflation will likewise decrease the COLA used to calculate social security benefits, meaning social security recipients will feel a decrease in their purchasing power through the next 10 years.  This switch from using CPI-U to C-CPI-U is part of how Obama’s budget attempts to close the budget deficit, and will be a contentious issue on Capitol Hill.

Thesis Paper for my Economics Degree

I am currently writing an article on inflation, which I feel is a good follow up to the CPI post.  Here is a link to the thesis paper I wrote for my Economics degree.  It was for an International Finance course and in the paper I test the statistical significancy of Purchasing Power Parity between 19 different countries from 1995 to 2010.   

Purchasing power parity essentially means that the price of a good in one country is the same as the price of the same good in another country once exchange rate is accounted for.  If purchasing power parity does not hold, then there is an opportunity for arbitrage, where someone can take advantage of this price difference between two markets by purchasing the good in the market with the lower relative cost, and selling it in a market with a higher relative cost. 

Interestingly enough, my paper shows that purchasing power parity did not hold between the selected 19 countries during that time period, even though the data fit the model quite well.  There are a number of reasons for how this is possible, many of which are discussed in the conclusion of the paper.  I believe the main reason is that the countries selected had varying levels of economic development and very different types of economies.  I chose countries with dissimilar economies since many of the countries I would have preferred to study faced currency reform (ie, the creation of the Euro) during that time period.  I hope to revisit this model and perform the regressions again using countries with developed economies in the near future.

Consumer Price Index

The prices of goods such as food, housing, and gas fluctuate from year to year.   An increase in the overall price level of goods and services is known as inflation, while a decrease in price levels is deflation.  To measure price fluctuations, the Bureau of Labor Statistics chooses a basket of goods which reflects the average spending patterns of urban consumers.  This basket is known as the Consumer Price Index, or CPI-U, and is the most common measure of price levels.

The CPI includes goods and services such as food, apparel, housing, transportation, education, entertainment, and medical care.  Goods such as gas and food are weighted more heavily than theater tickets since consumers must purchase them more frequently.  CPI is then calculated by taking the percentage increase or decrease of current price levels from price levels of a chosen base year.  Below is a graph of five different country’s CPI levels using 2000 as the base year:

This graph shows that Germany, Greece, the UK, and the US experienced inflation from 2000 to 2012 as price levels were continuously increasing.  Japan is the exception since the Yen deflated over this time period.  Yearly inflation or deflation rates are calculated using this CPI data by calculating the percentage change for each year.  The graph below shows the inflation and deflation rate of these countries during this time period:

 

Most of these country’s inflation rates hovered between 2 and 3%, which is generally the rate targeted by the Federal Reserve and European Central Bank.  The large decrease in inflation at the end of 2008 is from the collapse of the housing bubble as prices for many good in the CPI decreased. 

 

The CPI is the most common measure of price levels, but it is not a perfect measurement.  First, the CPI does not account for increases in the price of goods purchased by firms and governments (the Producer Price Index does).  Second, CPI does not account for substitution bias.  If apples are part of the basket, and the price of apples increases dramatically, consumers could substitute them for oranges and the CPI would not account for the switch.  Thirdly, there are some arguments that the CPI overstates inflation since a fixed basket cannot adjust for substitution, the introduction of new goods into the market, and changes in quality of goods.

 

These complications aside, the CPI is extremely useful for monitoring fluctuations in price and is frequently used by firms, governments, and central banks to make policy decisions.