September 22, 2017

Forget Friedman, forget the Quantity Theory

Comment on David Glasner on ‘Milton Friedman and the Chicago School of Debating’

Blog-Reference

In economics, there are two starting points, microfoundations and macrofoundations. Both are provably false. Orthodoxy went micro: “… most of what I and many others do is sorta-kinda neoclassical because it takes the maximization-and-equilibrium world as a starting point” (Krugman). Keynes went macro: “Income = value of output = consumption + investment. Saving = income - consumption. Therefore saving = investment.” (GT, p. 63)

Because both the axiomatic foundations of Walrasianism and Keynesianism are provably false their analytical superstructures are also false. This means, inter alia, that profit theory, price theory, employment theory, and money theory are false. Friedman never realized the necessity of a paradigm shift but remained faithful to a paradigm that had, strictly speaking, already been dead in the cradle 100+ years ago. As spokesperson for Monetarism, he incarnated the central tenet “that money causes prices”.

Because economics is a failed science it has to undergo a paradigm shift. Economic analysis has to be based on entirely new macrofoundations and the fundamental questions have to be put again at the top of the agenda.

Economics has to be reconstructed from scratch. As new analytical starting point, the pure production-consumption economy is defined with this set of macro axioms: (A0) The objectively given and most elementary configuration of the economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm. (A1) Yw=WL wage income Yw is equal to wage rate W times working hours. L, (A2) O=RL output O is equal to productivity R times working hours L, (A3) C=PX consumption expenditure C is equal to price P times quantity bought/sold X.

Under the conditions of market clearing X=O and budget balancing C=Yw in each period the price is given by P=W/R, i.e. the market clearing price is equal to unit wage costs. This is the most elementary form of the macroeconomic Law of Supply and Demand. For the graphical representation see Figure 1.#1


The price is determined by the wage rate, which takes the role of the nominal numéraire, and the productivity. The quantity of money is NOT among the price determinants. This puts Friedman’s Quantity Theory to rest.

Monetary profit for the economy as a whole is defined as Qm≡C−Yw and monetary saving as Sm≡Yw−C. It always holds Qm+Sm=0, in other words, the business sector’s deficit=loss (surplus=profit) equals the household sector’s surplus=saving (deficit=dissaving). This is the most elementary form of the Profit Law. Under the condition of budget balancing total monetary profit is zero.

What is needed for a start is two things (i) a central bank which creates money on its balance sheet in the form of deposits, and (ii), a legitimate sovereign who declares the central bank’s deposits as legal tender.

Deposit money is needed by the business sector to pay the workers who receive the wage income Yper period. The need is only temporary because the business sector gets the money back if the workers fully spend their income, i.e. if C=Yw.

Overdrafts are needed by the household sector for consumption expenditures if the households want to spend before they get their income. This time sequence is no problem for the central bank because the temporary overdrafts vanish with wage payments.

For the case of a balanced budget C=Yw, the idealized transaction sequence of deposits/ overdrafts of the household sector at the central bank over the course of one period is shown in Figure 2.#2


The household sector’s deposits/overdrafts are zero at the beginning and end of the period. The business sector’s transaction pattern is the exact mirror image. Money, that is, deposits at the central bank, is continually created and destroyed during the period under consideration. There is NO such thing as a fixed quantity of money. The central bank plays an accommodative role and simply supports the autonomous market transactions between the household and the business sector.

From this follows the average stock of transaction money as M=κYw, with k determined by the transaction pattern. In other words, the average stock 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 equation reads M=κPX=κRL P in the case of budget balancing C=Yand market clearing X=O and this yields the commonplace correlation between average stock of money M and price P for a given employment and productivity level, except for the fact that M is the DEPENDENT variable. If P doubles, M doubles. The commonplace correlation does NOT hold if L doubles and M doubles and P remains constant.

Inflation ensues under the condition of market clearing and budget balancing if the wage rate rises faster than the productivity and deflation ensues in the opposite case. Under the condition of L, R = const. one always gets the commonplace correlation between the average stock of money M and price P with the causality running from P to M.

This axiomatically correct kernel of the theory of money#3, which immediately makes it clear why the FED cannot reach the inflation target, fully replaces Friedman’s proto-scientific rubbish.

Egmont Kakarot-Handtke

#1 Wikimedia, Pure production-consumption economy
#2 Wikimedia, Idealized transaction pattern, household sector, balanced budget
#3 For more details see ‘Reconstructing the Quantity Theory (I)’. The New Quantity Theory formula is shown on Wikimedia.


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