Inflation Is A Nominal Phenomenon

2. Keynesian wrongly assumed a long run tradeoff between inflation and unemployment. While it is true that a tight monetary policy raises unemployment in the short run, it is not true that rising unemployment implies tight money, or lower inflation (as we saw in the 1970s.) For any given level of nominal GDP (M*V), a booming economy is actually deflationary. Low unemployment can co-exist with low inflation, as we saw in 2019. High unemployment can co-exist with high inflation, as we saw in 1981.

3. Keynesians typically don’t talk about velocity. But the claim that fiscal policy can control inflation is implicitly a claim that fiscal austerity reduces velocity. Nominal spending is M*V, so if you don’t plan to control the money supply, the only (demand-side) way to reduce inflation is by reducing velocity. Friedman didn’t think fiscal policy had much effect on velocity, and even if it did, it would at most be a modest one-time effect. If the Fed boosts the growth rate of the money supply from 5%/year to 10%/year (at a time of positive interest rates), you are almost certainly going to eventually end up with higher inflation. Even if a tax increase reduces the velocity of circulation by 2% in a single year, it will have almost no impact on longer run inflation, which is driven by rapid money growth.

Here’s very important distinction. If you boost money growth from 5% to 10%/year, if will cause inflation to be roughly 5% higher as long as the rapid money growth continues. Fiscal policy is not like that. Even if you permanently switch to a more expansionary fiscal policy, it will only cause a one-time increase in velocity. Monetary policy works by influencing a nominal variable (M), while fiscal policy works by influencing a real variable (V). It’s really hard to cause persistent inflation by influencing real variables like velocity.  In contrast, it’s easy to increase the money supply growth rate as much as you like.

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