Mankiw on Inflation and Interest Rates

 Posted by on 5 January 2010 at 8:00 am  Economics
Jan 052010

Harvard economist Greg Mankiw discusses why an exploding monetary base doesn’t necessarily translate into impending high inflation.

He notes that the frequently-circulated graph of money supply-vs.-time does look dramatic:

But he also emphasizes that the other critical factor that will determine whether significant inflation will occur is interest rate policy:

…But, you might ask, won’t the inflationary logic eventually take hold as the economy recovers and banks start lending more freely? Not necessarily. Recall that the Fed now pays interest on reserves. As long as the interest rate on reserves is high enough, banks should be happy to hold onto those excess reserves. That should prevent a surge in the monetary base from being inflationary.

Of course, interest rates are driven by decisions made by the Federal Reserve.

Hence, Mankiw concludes:

…[T]he worry should stem not from the monetary base but from the political economy and difficult tradeoffs facing monetary policymakers.

But as Yaron Brook notes, there is no way that the Fed can set a “correct” interest rate. Any rate they choose must necessarily be arbitrary:

So whether we experience inflation (or even worse, hyperinflation) will depend on arbitrary decisions made by politicians and bureaucrats — decisions that are necessarily detached from real-world market forces.

Maybe we’ll get lucky and dodge the hyperinflation bullet. Or maybe we won’t.

When rational markets aren’t allowed to operate, that’s all we can do — trust to luck…

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