Does the Money Supply Cause Inflation?

     In this whole debate over Sumner and the price level vs. the exchange rate, Tom seems to think that Sumner's claim that the price level is 100 times in Japan what they are in the U.S. is sound. It makes no sense to me as the exchange rate does have a ratio of 1 to 100 between the dollar and the yen respectively but surely the price level is something different as Greg argues here.

    "Looking for inflation in Japan, one must simply look in Japan and compare where they are today relative to 5 or 10 years ago. You don't need to look at dollar parity."

      http://diaryofarepublicanhater.blogspot.com/2013/09/mark-sadowski-responds-sumner-on.html

     Greg sounds right to me. However, Tom seems to think Sumner has said nothing wrong here. It could be-in the above link I ended up realizing that he hadn't said anything wrong in his definition of stagflation. My goal in all this genuinely is pursuit of the truth. So I have no problem admitting that there I was wrong to think he said something silly. He was correct though I wasn't familiar with that definition of stagflation-many other people weren't, including a establishment economist like Karl Smith.

     Though it's not an unfair question to ask whether a disinterested pursuit of truth is Sumner's overriding end with his admission that he doesn't care whether the EMH is true or not just that it's useful.

      http://diaryofarepublicanhater.blogspot.com/2013/09/sumner-emh-and-mistaking-beauty-for.html

     Yet the idea that the price level is 100 times higher in Japan seems absurd. However, tonight Tom offered this argument in the comments. I get it-I think. A little anyway though it's pretty tentative:

     Inspired in part by a piece he saw in a Forbes article, Tom argues that the price level is the average price of goods and services in a nation's economy.

     "So lets say country A is full of rich sheiks. In terms of gold, their average meal costs 1 oz of gold.

     "Now say country B is an impoverished 4th world country with few resources. Their average meal costs 1/1000 of an oz of gold."

      "Now if both countries used oz of gold for money (unit of account), obviously the price levels would be very different (say in both countries, selling meals is the entire economy)."

      "But now let's say country B adopts the B$, which they define as equal in value to 1/1000 of an oz in gold. And enough B$ are issued for all the citizens of B to turn in their gold to the CB in exchange for the far more convenient B$."

      "Guess what just happened? The price level equalized. A and B now have the same price level! The average price per good or service is now "1" in both countries: oz of gold in A and B$ in B. But the exchange rate from oz to B$ is 1:1000. Exchange rate and price level are thus NOT the same thing!"

      "Now let's say we add another good to the economy of both countries: the Hersey bar. In A the Hersey bar is the lowest form of food and sells for 1/1000 of an oz of gold. In B it sells for 1B$... so a Hershey bar is the same VALUE in both countries on an international absolute scale: both are 1/1000 of an oz, but the PRICE is very different in A compared to B, since it's measure in oz in A and B$ in B."

      "Now lets say A starts running low on funds and they fire up the oil wells again, and the Bentley dealerships, and diamond shops, etc. Now A is no longer a food-only-economy country... so the AVERAGE price per GOOD jumps up to 2 oz per good or service. Now the PRICE LEVEL (measured in oz of gold, and again here, the AVERAGE price per good or service sold) in country A is twice that of B. But the exchange rate is still 1:1000."

      "That's my read! Conclusion: the price level is not the exchange rate. The price level is also not the value level in terms of an absolute standard."

So to summarize:

1. Both countries on the gold standard, prior to Bentley dealerships re-opening in A:

Exchange rate A:B: 1:1
(Average) Price Level: A = 1, B = 1/1000
Hershey bar price: A = 1/1000, B = 1/1000

2. After B adopts the B$ as 1/1000 of oz of gold:

Exchange rate: A:B = 1:1000
(Average) Price Level: A = 1, B = 1
Hershey bar price: A = 1/1000, B = 1

3. After A opens Bentley dealerships:

Exchange rate: A:B = 1:1000
(Average) Price Level: A = 2, B = 1
Hershey bar price: A = 1/1000, B = 1 
  
     [END OF TOM's  QUOTE}

     http://diaryofarepublicanhater.blogspot.com/2013/09/sumner-and-difference-between-price.html?showComment=1379290334666#c2152718932695246316

     So it seems that between 1 and 2, the exchange rate and the price level switches places; in 1 the exchange rate is a ratio of 1 to 1 while the price level is 1 to 1000, in 2 the ratio of exchange is 1 to 1000 but now the price level is 1 to 1. Still in the Japanese case, according to what Sumner says the exchange rate and the price level are roughly the same-as the exchange rate is usually roughly 1 dollar to 100 yen. Tom's answer:

    "That would be true of countries A and C too, if they were both full of rich sheiks, and the average price (and value!) of goods and services sold were the same."

     "That might be approximately true between the US and Japan."

     It's likely true-I would be surprised if it weren't-that there is a rough parity in the price and value of U.S. goods and services vs. those in Japan. So I guess in this sense it adds up. Still, recall the initial context of this was that Sumner claims that only the Monetarist Quantity Theory of Money (QTM) can explain why the price level is 100 times greater in Japan-which for now, we will take Scott and Tom's word on and assume for the sake of this argument. 

    "So let’s start with an economy that has “normal” (i.e. non-zero) interest rates, and non-interest-bearing base money.  How does the price level get determined in that case?  I’m told there are some theories of fiat money that suggest it must evolve from commodity money.  I don’t agree.  I think the quantity theory of money is all we need.  Suppose you dump 300,000 Europeans on an uninhabited island—call it Iceland.  The ship also drops off some crates of Monopoly money, and they’re told to use it as currency.  Assume no growth for simplicity.  Also assume no government and no banking system.  It’s likely that NGDP will end up being roughly 15 to 50 times the value of the stock of currency.  Once you pin down NGDP, then you figure out RGDP using real growth theories, and voila, you’ve got the price level.  At this point you might be thinking; “you consider ’15 to 50 times the currency stock’ to be a precise scientific solution?”  No, but it gets us in the ball park.  It tells us why prices are not 100 times higher than they are, or 1000 times higher.   BTW, prices in Japan are 100 times higher than in the US, and Korean prices are 1000 times higher.  I don’t see how other theories can even get us into the right ball park."

     http://www.themoneyillusion.com/?p=10116

     This was the post that I quoted from that initially led Greg to focus on this claim of Sumner's regarding the price level in Japan. The one thing I still would ask you for Greg is if you can find the link to the back and forth in the comments you had with Sumner as I'd still like a look at that.

     Now, even though we are for now assuming Tom is right and Scott's claim here is fine-though even Sadowski agreed with me that it's confusing; which I read as meaning there is more than one way to define the price level-interestingly enough the article that led Tom to this explanation at the same time also makes a strongly anti-Monetarist argument, where the Forbes' writer states flatly that increasing the monetary supply does not increase inflation.  Indeed, the recent Fed actions seems to verify this as we've seen the Fed balance sheet close to triple and yet we have seen no spike in inflation-quite the opposite it's just above 1%  now. I like this Forbes guy:

    "It is conventional wisdom that printing more money causes inflation. This is why we are seeing so many warnings today of how Quantitative Easing I and II and the federal government’s deficit are about to lead to skyrocketing prices. The only problem is, it’s not true. That’s not how inflation works. Hence, this is yet another of the false alarms being raised (along with the need to balance the budget) that is preventing us from doing what we need to do to recover from the worse recession since the Great Depression."

   http://www.forbes.com/sites/johntharvey/2011/05/14/money-growth-does-not-cause-inflation/4/

   As Harvey explains, no one can-or wants to-deny that MV=PY as it is just a simple identity. However, what the Monetarists never admit is how many special assumptions they need to show that raising the money supply-and only raising the money supply-can raise the inflation rate.

   "It is important to note here that the above is not the least bit controversial. No economist disagrees with the basic equation MV=Py. The arguments arise when additional assumptions are made regarding the nature of the individual variables. For example, this is what is assumed in the “money growth==>inflation” view:

M: That which is money is easily defined and identified and only the central bank can affect it’s supply, which it can do with autonomy and precision.

V: The velocity of money is related to people’s habits and the structure of the financial system. It is, therefore, relatively constant.

P: The economy is so competitive that neither firms nor workers are free to change what they charge for their goods and services without there having been a change in the underlying forces driving supply and demand in their market.

y: The economy automatically tends towards full employment and thus y (the existing volume of goods and services) is as large as it can be at any given moment (although it grows over time).

     [ END OF HARVEY'S QUOTE ]
      
     In reality we see that all these special assumptions basically never all hang together at the same time. Certainly as we learned in the failed Monetarist experiment in Britain in the 80s V is far from stable. As for Y, this rests on the assumption of there being only one equilibrium-a full employment or after Friedman 'natural unemployment rate' equilibrium-or NAIRU. Without all these assumptions the Monetarist theory falls apart.