Good summary of points 🙂

You are exactly right that higher oil prices can be deflationary, in so far as the higher relative price of fuel leads to downward pressure on all other prices in the economy. This is picked up by the CPI in time. However, I’m glad that you mentioned that there are problems with the CPI measure – after the post on inflation targeting that is coming up I was going to post about inflation measurement 🙂

In New Zealand, petrol prices will reduce demand, which will reduce price pressure. However, petrol is also an input to production, so this will increase price pressure.

When it comes to inflation another important question to ask is – how will workers and firms bid up prices in order to compensate themselves for the increase in petrol prices. If people take higher petrol prices as a sign that price growth is going to be greater in the future, then it will be inflationary.

So this is what I understand:
The I in CPI stands for ‘index’, not ‘inflation’. The CPI is an index that tells us how much prices have changed across a standardised basket of products that are purchased by consumers. Hence: consumer price index.

Changes in the CPI are used as shorthand for the amount of inflation because when there is x% inflation there is expected to be an equal x% general increase in prices. This doesn’t say what inflation is. I will come to that.

But the problem with that index is that it is a standardised basket of products. It assumes the mix of products stays relatively constant. To be a useful comparison over time it needs to keep a pretty constant mix. The problem is that the weighting of products in the economy is constantly changing, not least because of relative price changes. For example, the amount of petrol purchased is changing as the price rises relative to everything else.

I think you rightly say that the amount of money in the economy, adjusted for velocity, is a measure of money supply.

And I think you are right to say that if money supply increases, prices can be expected to increase, all other factors being equal. My understanding is that inflation is a measure of the increase in the money supply, and rising general price levels is the result of inflation.

My understanding of monetary policy as a way to keep prices under control, is that it works as follows: increasing money supply leads to rising prices, so to prevent rising prices we take money out of the hands of those who spend it, namely consumers. To take money out of the hands of consumers we raise interest rates, which reduces the amount of money consumers have available for discretionary spend. This works really well if everyone in the economy is exposed to variable interest rates, which was the mostly case when monetary policy was first used to control inflation. The speed at which a change in interest rates can drive a change in spending is influenced by how quickly that change in rates sucks money out of the hands of consumers and businesses.

(And as an aside, the cost of controlling prices is borne by that portion of society for whom changes in interest rates causes immediate change in the amount of money they have available to spend. And to avoid that cost most of those who can have switched their borrowing to fixed interest rates over longer periods of time. And the result is that for interest rate changes to impact on prices it now takes a greater amount of change in rates, and a longer time, to suck the requisite amount of money out of the economy, and the cost is felt by a smaller group).

Now along comes an increase in the world price of oil. Prices of oil rise at the pumps. Everyone is exposed to the price of oil, and more money is spent on that oil. What happens to the supply of money in our economy? It gets reduced because the money is sent overseas to buy the oil. So a rise in the price of oil has the same inpact on money supply as a rise in the interest rate.

So by my definition of inflation, a rise in the world price of oil is deflationary in New Zealand because it reduces money supply.

Of course, it makes the CPI rise by the weighted average of the price change for petrol times the proportion that petrol makes up of the basket of goods.

Similarly rises in the price of imported food and other products does the same thing. But only to the extent that it is driven by remittances that reduct the money supply in the hands of NZ consumers.

Offsetting this to some extent is the world price of milk and other agricultural produce that we export. That brings more money into the NZ money supply, but the impact of that (both the size and how long it takes) is impacted by what the people who receive that extra money decide to do with it. What are the farmers doing with their windfall gains? Are they spending up large providing additonal employment within NZ, or are they socking the money away in the bank, paying off debt, etc? My guess is it is a bit of both, but with a slowing economy and falling confidence, these naturally conservative people will be salting a good proportion away for the rainy (or very dry) days ahead. So rising agricultural export prices and rising fuel and food import prices will not have an equal and offsetting impact on the economy.

So the upshot of all this? Rising import prices are probably having a greater deflationary effect than rising export prices are offsetting, in terms of the money supply. But a high indicator of inflation, CPI, suggests (incorrectly) that interest rates should be high. High interest rates are the wrong answer.

Of course, it is not all that simple. If we lower interest rates our exchange rate will probably fall, and those imports will become even more expensive in local terms. So someone needs to do the sums to work out the magnitude of that change. Lower exchange rates would help exporters to get busier, putting more money into the the hands of consumers. Not a bad result.

I am sure the real economists out there will be able to tell me why my understanding is all wrong. I look forward to more comments.

Thanks for the comment on the real bills doctrine. My feeling was that the real bills doctrine is merely another way of fixing the money supply – and as a result is completely consistent with the general view of the quantity theory of money.

The only problem with fixing the money supply so directly is it ignores the demand side of the issue – a large increase in the national production will require a greater supply of money to keep the general price level unchanged. As fixing the money supply does not respond to this you end up with a leap in the interest rate and deflation.

Very well said. Thanks for your regular updates….

Exactly right – my definition was not appropriate in that sense as it seemed to include one-off price level adjustments.

In that sense I should have been clearer that I was discussing a “rate of change” in the price level, rather than a shift. Thanks 🙂