There is nothing new in the substance of this post; it is an exposition of standard monetary theory. (Though some might find the exposition interesting.)

It is an open invitation for people to tell me where standard monetary theory of the effects of inflation might be wrong.

It's an invitation open to all, but I do have Austrian economists especially in mind. As far as I can tell, one of the main points of disagreement between Austrians and other monetary theorists concerns non-super-neutralities of money. Both believe money is not super-neutral, but Austrians seem to argue for an additional non-super-neutrality that is not present in non-Austrian monetary theory.

This matters, because I interpret Austrians to argue that the seeds of recessions like the current one are sown by monetary inflation.

First some terminology. A "nominal" variable is usually defined as one which has $ in the units; a "real" variable is one measured in physical (or non-monetary) units. (This doesn't work exactly, because both nominal and real interest rates have the units 1/time, but I am going to ignore this flaw in the definitions.)

Money is "neutral" if a change in the level of the stock of money has no effect on real variables (it only affects nominal variables).

Money is "super-neutral" if a change in the growth rate of the stock of money has no effect on real variables (it only affects the growth rate of nominal variables).

[Note to Post-Keynesians: I have defined neutrality and super-neutrality implicitly assuming "money" is exogenous; but it would be easy for me to redefine them taking any nominal variable as the exogenous control instrument or target. Indeed, my thought-experiment below makes no distinction at all between endogenous and exogenous variables.]

Standard theory says that both neutrality and super-neutrality are false in the short run. The main reason is that prices do not adjust instantly.

Standard theory says that neutrality is true in the long run (with careful caveats), where prices are assumed perfectly flexible in the long run.

Standard theory recognises that super-neutrality is not precisely true in the long run. There are some non-trivial real effects of an increase in the growth rate of the money supply. Inflation does matter in the long run.

Let us see what those real effects might be. But first, let me explain my approach.

There are two ways to solve simultaneous equations. The first way is the way (or ways) they taught you in school. The second way is to guess the answer, then check to see if your guess is correct. I'm going to use that second way. This is often how economists solve for an equilibrium. They guess what the equilibrium might look like, then check to see if their guess makes sense.

My initial guess is that money is super-neutral.

There are two economies, A and B, running side-by-side in parallel universes. At any point in time, the real variables are exactly the same in A and B. They have the same real resources, technology, population, preferences, produce the same quantities of all goods, and have the same employment, relative prices, real incomes, real savings and investment, real growth rates, etc. But B has higher inflation than A. Let's say inflation is 10% (10 percentage points) higher in B than in A. And the money supply (defined in all possible ways) is also growing 10% faster in B than in A. And it's not just average inflation that is 10% higher in B than in A; each individual price (or wage) is also growing 10% faster in B than in A. And nominal interest rates are also 10% higher in B than in A. But real interest rates (nominal interest rates minus inflation, however defined) are the same in A and B.

That's my initial guess. If it were true, money would be super-neutral. We wouldn't care about inflation, since we only care about real things.

Now, my initial guess is wrong. Here are the standard reasons why we know it's wrong (the non-super-neutralities of money):

1. If we assume that currency pays no interest, then the real interest rate on currency must be 10% lower in B than in A. This is the inflation tax on money (or currency). If we assume that the demand for money is a (negative) function of the real rate of return on money, then the real demand for money must be lower in B than in A, so in equilibrium the real stock of money M/P must be lower in B than in A.

2. If the money supply is growing 10% faster in B than in A, the central bank must be printing more money in B than in A, and will be earning higher real profits from seigniorage. (I'm assuming we are still on the right side of the Laffer curve for the inflation tax, so that the smaller M/P effect does not offset the bigger Mdot/M effect). And the higher profits will add to government revenue. This means government expenditure can be higher, or other taxes lower. To get a rough estimate of the size of this seigniorage, assume currency is 5% of GDP (in the ballpark for Canada), so a 10% higher money growth rate would create at most (ignoring the downward slope of the money demand curve) extra seigniorage of 0.5% of GDP. (And the Bank of Canada would see its annual profit fall from the current $2 billion to about $0.5 billion if it cut the inflation target from 2% to 0%.)

3. If nominal interest rates cannot go negative, and the same shock hit economies A and B, that shock might cause some nominal interest rates to hit the 0% lower bound in A but would leave them above the 0% lower bound in B. (Remember that nominal interest rates in B are guessed to be 10% higher than in A).

4. If nominal prices (and wages) are short run sticky, then nominal prices must either change more frequently in B than in A, or else change by bigger amounts when they do change. This may cause bigger costs of changing prices (menu costs) and/or bigger (inefficient) fluctuations in relative prices in B than in A. (The same applies to adjusting tax rates, minimum wages, etc..)

5. People may just get confused by a changing value of money as a device to measure values of goods, and never adjust to inflation. At the very least, when deciding whether this is a good price for eggs they will need to remember when exactly it was they last saw eggs at $2 a dozen.

6. I've probably forgotten some non-super-neutralities.

So, tell me where this list is incomplete, or wrong.

One at a time please!