The importance of inflationary expectations: The 1870s vs. the 1970s
There's an interesting contrast between the 1870s and the 1970s. Both decades were significantly influenced by a suspension of the gold standard, and currency inflation. In the case of the 1870s, greenbacks were (temporarily) not convertible to gold as a leftover of a Civil War measure, and the price inflation that resulted from issuing paper currency to finance the war. The 1970s should be more familiar: The US finished abandoning the gold standard in the late 1960s and early 1970s for a variety of reasons, including foreign exchange rates and the large amount of gold required to back the necessary currency.
The striking difference is one of expectations: In the 1870s, the strong expectation was that despite substantial inflation (peak prices about doubled), gold convertibility would be restored, at par. This effect alone significantly limited inflation: Apparently a significant amount of foreign investment bought dollars (and then invested those in railroad bonds), in the expectation of those dollars buying significantly more gold after a matter years. So the lower the dollar fell, the more foreign exchange was likely to prop it up. (Assuming, as was borne out, that the expectation of eventual convertibility persisted.)
In contrast, the 1970s offered no particular reason to believe that inflation would moderate, and the dollar's value kept falling.
This seems relevant to the current situation in terms of understanding the Federal Reserve. If they announced that they had decided to inflate the currency, the currency would probably do just that. In addition, foreigners who currently hold a lot of dollars (or dollar-denominated investments: Treasury bonds in particular) would try to sell, causing a steep decline in foreign exchange rates. It appears to me that the apparent intentions of the Federal Reserve, by itself, are strongly affecting inflation rates. (This is a good thing: Recession is bad, recession with inflation is worse.)
I'm consequently puzzled by commentators (Krugman in particular) asking why the Fed would talk tough about inflation: They pretty much need to.
The striking difference is one of expectations: In the 1870s, the strong expectation was that despite substantial inflation (peak prices about doubled), gold convertibility would be restored, at par. This effect alone significantly limited inflation: Apparently a significant amount of foreign investment bought dollars (and then invested those in railroad bonds), in the expectation of those dollars buying significantly more gold after a matter years. So the lower the dollar fell, the more foreign exchange was likely to prop it up. (Assuming, as was borne out, that the expectation of eventual convertibility persisted.)
In contrast, the 1970s offered no particular reason to believe that inflation would moderate, and the dollar's value kept falling.
This seems relevant to the current situation in terms of understanding the Federal Reserve. If they announced that they had decided to inflate the currency, the currency would probably do just that. In addition, foreigners who currently hold a lot of dollars (or dollar-denominated investments: Treasury bonds in particular) would try to sell, causing a steep decline in foreign exchange rates. It appears to me that the apparent intentions of the Federal Reserve, by itself, are strongly affecting inflation rates. (This is a good thing: Recession is bad, recession with inflation is worse.)
I'm consequently puzzled by commentators (Krugman in particular) asking why the Fed would talk tough about inflation: They pretty much need to.