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Mar 10, 2009

Use Inflation to Fool People

We Were All Keynesians Then
01/09/06 - Cato.org by economist Ike Brannon
(via The Angry Economist)

Keynesian economists expect most people to be slow-witted and unable to make rational economic decisions. The government tries to fool people into working harder by inflating the currency to just the right amount. But, it doesn't work for long.

[edited] In 1961, John Muth published in the journal Econometrica, demonstrating that people thoughtfully use available information to predict future prices, and then make economic decisions based on "rational expectations".

Muth's insight was radical during that heyday of Keynesian economics. Today, it is an accepted part of the canon of economics.

"Rational expectations" says that entrepreneurs and workers do not assume that prices will be constant when they need to forecast future prices. They use all available information to estimate what prices will be, and their estimate is correct on average. They will make mistakes, but they will not be consistently wrong.

Muth demonstrated that rational expectations explained prices quite well for a market in hogs, thought to exhibit wide, predictable price swings.

Muth's paper was published at the time that Keynesian economics had become ascendant in the political world. Policymakers thought they could permanently increase employment by increasing inflation. Supposedly, higher inflation fools workers, who mistake a rising dollar wage for a real increase in their buying power. As a result, people would take jobs they would not otherwise take, and work more hours than they would otherwise work, increasing employment and output.

Muth's work explains why the 1970's economy experienced "stagflation", slow economic growth and inflation at the same time. Rational expectations predicted that people may not always make economically optimal decisions, but they can't be consistently fooled by government policies.

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