Scott Sumner has an excellent post up, in which he argues that everything New Keynesian economists say causes inflation is actually an impediment to inflation.
Now let’s say I am wrong about rational expectations and flexible prices. Then what? Let’s say the people who live in my island economy are a bit “slow” and don’t understand that the extra $1 billion in Monopoly money that washed up on the beach will soon cause the price level to double. What then? In that case you get an overheated economy, with excess demand. The price level does not immediately double; rather it doubles over a period of weeks or months, as people eagerly spend their new wealth on goods and services.
Only an idiot (or a brilliant saltwater economist) would think that this excess demand is causing the inflation. Indeed if there were no excess demand we’d be back in the currency reform case, where prices immediately double. The excess demand resulting from sticky prices is actually slowing the upward adjustment in prices.
I think he’s wrong about this though. If a bunch of extra money showed up in his island economy, then the folks who had it would initially be inclined to hoard it. Prices wouldn’t go up because money in circulation would not go up. Having lots of money in a realm of stable prices makes those who have it feel wealthier. This induces them to buy things and lets the money leak out into circulation. Excess demand is the transmission mechanism of the currency from the crate to general circulation.
Scott touches on this in when he adds the complexity of a financial sector:
Now let’s add a financial market to the island economy. After the crate of money washes up on the beach, the lucky islanders who first discover the crate have more money than they wish to hold. They exchange this money for other assets, which depresses interest rates. Of course eventually prices will double and then they really will be happy to hold twice as much cash as before. Interest rates will return to normal. But during the transition period the interest rate will fall, which depresses the velocity of circulation. The reduced velocity slows inflation. So money is not neutral in the short run. But only an idiot (or a brilliant saltwater economist) would claim that the lower interest rates cause the inflation. Indeed if interest rates did not decline and velocity stayed the same, then prices would rise much faster. The tendency for interest rates and velocity to initially decline due to sticky prices actually slows the upward adjustment in prices.
The chain of causality is harder to spot but let me try to trace it out. The lucky islanders, having more money than they wish to hold, attempt to buy assets. This causes excess demand in asset markets. It’s the re-equilibration of the of supply and demand in the asset market which both leads to a fall in interest rates and in an increase in the money holdings of non-lucky islanders. This increase in money holdings is the mechanism by which the extra currency gets into circulation.
How can we know this? Imagine that there is a strictly enforced rule on the island that only allows asset markets to trade on the first of the month. The crates of money wash up on the 2nd. What happens for the next 29 days? The lucky islanders will hold their currency until the markets open. Prices cannot change because there is no money in circulation to induce the change.
Then on the 2nd there will be a rush as the lucky islander try to buy up all the bonds, which is the same as making loans. This causes bond prices to rise and equivalently interest rates to fall. Unlucky islanders see the opportunity will create new bonds to sell, which is the same as borrowing money. The unlucky islanders will now have more money in their hands which will raise currency in circulation.
It’s actually this central problem, that money has to get into circulation before inflation can occur, which would prompt people to put money into circulation that is at the heart of Keynes’s observation.
Thirdly, we come to what is the most fundamental consideration in this context, namely, the characteristics of money which satisfy liquidity-preference. For, in certain circumstances such as will often occur, these will cause the rate of interest to be insensitive, particularly below a certain figure, even to a substantial increase in the quantity of money in proportion to other forms of wealth. In other words, beyond a certain point money’s yield from liquidity does not fall in response to an increase in its quantity to anything approaching the extent to which the yield from other types of assets falls when their quantity is comparably increased.
In this connection the low (or negligible) carrying-costs of money play an essential part. For if its carrying-costs were material, they would offset the effect of expectations as to the prospective value of money at future dates.
Now there are ways around this: price changing rules-of-thumb, highly co-ordinated expectations, and most importantly, financial markets. But, if those mechanisms break down, then the monetary transmission will break down as well.