Saturday , July 11 2020
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Nick Rowe on money illusion

Summary:
Craig Fratrik sent me a Nick Rowe twitter thread discussing the way that central banks create a nominal anchor. I think I agree with the substance of the thread, but I’m not certain. My hesitation has to do with what seems like an unconventional use of terms like “rational” and “money illusion”. I hope commenters will tell me whether I actually disagree with Nick, or if we just define terms differently. Here’s a portion of the thread: I’d like to present two imaginary conversations. Both occur in a country where inflation has been running at 10%/years for several decades: First conversation: Jack: I’m bummed out. Jill: Why is that? Jack: My boss just gave me a lousy 6% pay raise for next year. Jill: Yikes, that’s not very much given the 10%

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Craig Fratrik sent me a Nick Rowe twitter thread discussing the way that central banks create a nominal anchor. I think I agree with the substance of the thread, but I’m not certain. My hesitation has to do with what seems like an unconventional use of terms like “rational” and “money illusion”. I hope commenters will tell me whether I actually disagree with Nick, or if we just define terms differently. Here’s a portion of the thread:

Nick Rowe on money illusion

I’d like to present two imaginary conversations. Both occur in a country where inflation has been running at 10%/years for several decades:

First conversation:

Jack: I’m bummed out.

Jill: Why is that?

Jack: My boss just gave me a lousy 6% pay raise for next year.

Jill: Yikes, that’s not very much given the 10% inflation rate.

Second conversation:

Jack: I’m on cloud nine today.

Jill: Why is that?

Jack: My boss just gave me a 6% pay raise for next year!

Jill: Umm, you do know that the inflation rate is 10%?

In both conservations, Jack is describing his situation using an unstable measuring stick—money. His account of his pay raise is in money terms, and by itself doesn’t accurately convey his actual economic situation. On the other hand, in the first conversation Jack seems well aware of the 10% inflation rate, and understands that his real wage is declining. In the second he does not. In my view, the second conversation exhibits irrational behavior and money illusion, while the first conversation does not.

As I read Nicks twitter thread (especially #9), it almost seems like he’s saying that merely setting monetary measures of value is ipso facto evidence or irrationality, or money illusion?

Do I have a substantive difference with Nick, or is this just semantics?

My view is that the “public good” aspect of money is so strong that even a highly flawed numeraire is far superior to no numeraire at all. I believe that it’s more rational to talk about a 6% raise in a world of 10% inflation than to talk about one’s pay raise without any reference to a numeraire. I don’t want someone telling me that last year they got paid 30 shares of Google stock per month and this year their pay was changed to 40 ounces of gold per month. I want all my information in dollars. The math is easier and I’ll sort out the real implications myself.


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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