An implausible theory of inflation: A Reply

Abstract

criticizing our critique of the theory outlined by Dornbusch and Fischer [1986], Diehl argues that "a carefully conducted solution of the monetary model is able to defeat" these arguments (Diehl, p. 614), i.e, our criticism. However, his "carefully conducted solution" endows the model presented by Dornbusch and Fischer with additional properties and assumptions nowhere to be found in the article which we criticized. (This, incidentally, explains the fact that we never quoted the "solution" by Sargent and Wallace [1973] of the "paradox" also appearing in the paper by Dornbusch and Fischer.) We therefore could stop our reply to Diehl's paper right here claiming complete innocence to his charges since we obviously did not commit the crime that he charged us with, as any reader of both the article by Dornbusch and Fischer and our remarks can verify. However, the issues raised by Diehl seem to be important enough on their own account. We therefore welcome the opportunity to comment briefly on Diehl's theory. First, Diehl seems to suggest that not the "seignorage," i.e., the real value of the government's budget deficit, is the variable of the model which the government aims to control, but the nominal money supply (Diehl, p. 616). Diehl contrasts this with our argument which considered three different ranges of the real budget deficit as given and derived the implied path of the inflation rate. He clearly errs when he thinks that we have assumed that the real budget deficit in the model by Dornbusch and Fischer must be a constant. That this cannot be true follows already from the fact that the implied qualitative development of the demand for real balances is the same for any value which the deficit assumes within each of the three ranges. On the other hand, our position is a far cry indeed from devising such a time path of the deficit that Diehl's special money supply policy follows. This, together with a certain pattern of the formation of expectations on the part of the public, leads to the saw-tooth motion of the inflation rate which Diehl finally derives.