August 7, 2017

Inflation: back to basics

Comment on David Andolfatto on ‘A monetary-fiscal theory of inflation’

Blog-Reference and Blog-Reference on Aug 8

David Andolfatto argues from a sophisticated model: “In my formal model, I have a parameter that indexes the growth rate in the demand for real money/bond balances (where money and bonds take the form of USDs and USTs, respectively). In the open-economy version of my model, I have a ‘money demand growth regime’ originating from the foreign sector. In the model, this regime translates into persistent U.S. trade deficits, representing the foreign sector's desire to acquire USD/UST at an elevated pace.”

Basically, in this model deflation/inflation is driven by what happens on the UST market. This is in line with the commonplace Quantity Theory which holds that a smaller or broader composite called ‘quantity of money’ determines the price level.

Now, it is well-known that the familiar models, which are either from the Walrasian type (= microfoundations) or the Keynesian type (= macrofoundations), are axiomatically false. Because of this, monetary theory has to be based upon entirely new macrofoundations.#1

In order to go back to the basics, the pure production-consumption economy is for a start clearly defined by three macro axioms (Yw=WL, O=RL, C=PX), two conditions (X=O, C=Yw) and two definitions (profit/loss Qm≡C−Yw, saving/dissaving Sm≡Yw−C).#2

Money is needed by the business sector to pay the workers who receive the wage income Yw per period. The workers spend C per period. Given the two conditions, the market clearing price is derived for a start as P=C/X=W/R. So, the price P is determined by the wage rate W, which has to be fixed as a numéraire, and the productivity R. From this follows the average stock of transaction money as M=κYw, with k determined by the payment pattern. In other words, the quantity of money M is determined by the AUTONOMOUS transactions of the household and business sector and created out of nothing by the central bank. The economy never runs out of money.

The transaction formula reads M=κ max(1, ρE) PX= κ (max(1, ρE) RL) P, with the ratio ρE defined as C/Yw, and this yields the commonplace correlation between quantity of money M and price P, except for the fact that M is the DEPENDENT variable.

The market clearing price is given in the general case with the price formula, a.k.a. Law of Supply and Demand:
An expenditure ratio ρE greater than 1 indicates credit expansion = dissaving, a ratio ρE less than 1 indicates credit contraction = saving. In the initial period ρE = 1, i.e. the household sector’s budget is balanced. The ratio ρE establishes the link between the product market and the money/capital market.

Now we have deficit spending, i.e. ρE greater 1, yields a price hike. If deficit spending is repeated period after period the price remains on the elevated level but there is NO inflation. No matter how long the household sector’s debt increases, there is NO accelerated price increase.

The price formula makes it clear that inflation only occurs if the wage rate W increases in successive periods faster than productivity R. This can happen at ANY employment level. It is NOT a precondition that employment is close to the capacity limit. This is merely a false interpretation of the Phillips curve.

The current deflationary trend is caused by the fact that (worldwide) wages lag behind productivity growth. To turn this trend around it does not matter much what happens on the market for UST, what matters is that governments/central banks engineer a coordinated worldwide increase of the average wage rate.

Egmont Kakarot-Handtke

#1 First Lecture in New Economic Thinking
#2 For the detailed description see ‘How the intelligent non-economist can refute every economist hands down

Preceding 'A la recherche de l'inflation perdue' and 'Going beyond No-Idea economics' and 'Putting economic policy on scientific foundations'

Related 'Essentials of Constructive Heterodoxy: Money, Credit, Interest' and 'Essentials of Constructive Heterodoxy: Financial Markets' and 'Forget Friedman, forget the Quantity Theory' and 'MMT was right all along: Gov-Deficits do NOT cause inflation'.