Primer: Agreement The Post-Keynesian Rejection Of Mainstream Inflation Theory

From the perspective of conventional economical analysis, the post-Keynesian approach to inflation is mystifying. If nosotros focus on the Modern Monetary Theory (MMT) schoolhouse of thought inward particular, it is real slow to either uncovering claims that "MMT has no theory of inflation," or non-MMTers "explain" the MMT inflation theory is some random trivial human relationship that they simply made up. The key to understanding post-Keynesian approaches is that it takes a completely dissimilar approach to understanding inflation, too outcomes are seen every bit real hard to forecast.

This article is based on Section 8.1.1 ("The Rejection of the Acceleratoinist Thesis") of Professor Marc Lavoie's splendid Post-Keynesian Economics: New Foundations (link to my review). From the perspective of a non-academic, a pregnant portion of the majority would probable travel constitute every bit arcane, too could easily travel confusing to a non-specialist. However, Section 8.1.1 is extremely straightforward, too the most hard business office of my writing chore hither is staying inside "fair use" copyright limitations when describing it...

(Since I raised the number of MMT earlier, I cannot say whether in that location are whatsoever major disagreements betwixt MMTers too Lavoie's description of post-Keynesian thinking on inflation. My feeling is that in that location is cypher that a non-academic would larn also excited about, other than the importance that MMT ascribes to the Job Guarantee wage inward stabilising inflation. For the analysis of a province without a Job Guarantee -- currently, all of them -- this distinction has no practical import.)

Setting upward a Mainstream Straw Man

One of the problems amongst post-Keynesian thinking is that it largely seems to travel defined inward a negative fashion: it appears to travel simply a random laid of complaints nearly "mainstream" economics. Although I would prefer to avoid developing the give-and-take this way, it seems to travel the best agency frontward inward this circumstance. I lead maintain been writing too reading economical commentary produced inward the financial markets every bit good every bit the cyberspace for a real long time, too I would fighting that in that location is a for certain "conventional" reason persuasion that is widely shared past times writers too readers, fifty-fifty if they make non qualify every bit "mainstream." I intend it is best to seem upward these conventional views direct past times setting upward an overly-simplified version of the thinking -- a straw human being -- too and therefore explicate what parts of the straw human being persuasion are viewed every bit completely out-of-paradigm. (Please notation that my give-and-take inward this department is non based on Lavoie's text; I render to his logic later. Another notation is that this give-and-take applies to inflation theories, every bit a practical matter, fifty-fifty "mainstream" economists are closer to where I am on the matter.)

When I larn around to writing a text on competing inflation theories, I volition too therefore run through the diverse variants, too give them an honest critique. For now, I simply desire to re-orient the give-and-take inward a for certain direction.

H5N1 fairly typical mainstream approach is to create models around transactions betwixt agents amongst an endowment of goods/resources (including labour power) at a indicate inward time; "dynamics" are allegedly introduced past times introducing frontward markets. Prices are (somehow) determined for this vector of goods/resources simultaneously, too and therefore agents human activity (work/consume) based on maximising utility based on that vector of prices.

The adjacent pace is to lump all non-financial goods/resources into 2 buckets: labour, too an aggregate good. Therefore, in that location are 2 existent economic scheme prices that matter: the wage rate, too the aggregate toll grade (there are financial prices every bit well, such every bit the toll of Treasury bills, every bit good every bit money, which is defined to lead maintain a toll of 1).

We too therefore engage inward diverse arguments to enter at the conclusion that wage rates are related to the marginal productivity of labour (in terms of the aggregate good), too therefore nosotros solely lead maintain ane existent economic scheme toll that matters: the coin cost of the aggregate good.

If nosotros pace away from theory, economists determine ane exceptional toll index is "the" toll grade of the economy, too therefore it is equivalent to the coin toll of the aggregate proficient inward economical theory. Inflation is the charge per unit of measurement of modify of this aggregate price.

(The exception to the conventional wisdom would appear to travel Austrian economists, who lead maintain an aversion to aggregating the toll level. Instead, they seem to define "inflation" every bit the modify inward the coin stock, which may or may non travel related to changes inward the measured CPI. Since Austrian economic science is forthwith largely a financial markets too cyberspace phenomenon, it's hard to give a create clean theoretical summary.)

We tin forthwith define what inflation theory is: the theory that allows us to predict the changes inward some toll index, which I volition refer to every bit the consumer toll index (CPI) hither for simplicity. Everyone scurries off inward diverse directions at this point, but the green resultant is that in that location is an endeavor to slap together a reduced cast model (that is, computationally tractable) that allows us to forecast the modify inward the toll level, based on a few economical fourth dimension series.

It should travel underlined that practically everyone does this (including me, inward my before life). For example, it is non hard to uncovering physicists who opine on economic science on the cyberspace that create models that assume that in that location is a reduced cast human relationship betwixt other economical variables too changes inward the CPI; finding that reduced cast model is simply doing empirical work!

The post-Keynesian rejoinder is: non therefore fast.

Rejecting Reduced Form Models

It would travel an exaggeration to say that post-Keynesians spend upward all reduced cast models, rather they spend upward pretty good all the ones that the mainstream has proposed.

The start laid of objections is anything based on the coin supply. Marc Lavoie, on page 541:

In post-Keynesian theory, the grade of the coin provide does non determine the grade of prices; nor does the charge per unit of measurement of increase of the coin provide determine the charge per unit of measurement of inflation. Excess coin or monetized authorities deficits are non a proximate crusade of inflation, non fifty-fifty inward the instance of the High German hyperinflation of the 1920s, every bit argued past times Burkedin too Burkett (1992) too Wray (2012, pp. 246-57), nor inward the instance of the 'Great Inflation' inward England inward the 1500s, ordinarily attributed to golden discoveries (Arestis too Howells, 2001-02).

We tin too therefore larn after NAIRU (page 542):

... post-Keynesians spend upward the concept of the natural charge per unit of measurement of interest, too they lead maintain real footling faith inward natural charge per unit of measurement of unemployment or the NAIRU.

He quotes Wynne Godley (from the compilation Keynes too the Modern World, published inward 1993, page 170):

Indeed if [emphasis inward original] it is truthful that in that location is a unique NAIRU, that genuinely is the terminate of give-and-take of macroeconomic policy. At nowadays I lead house not to believe it too in that location is no show of it. And I am prepared to limited the value judgment* that moderately higher inflation rates are an acceptable toll to pay for lower unemployment. But I make non lead maintain that is a foregone conclusion that inflation volition travel higher if unemployment is lower. 

Conventional economists lead maintain an extremely broad gain of variants of the notion of excess demand beyond the notion of the NAIRU, including concepts similar the output gap (which tin travel operationally defined inward many ways). From their perspective, all of these concepts are extremely different, although I am non real convinced that they are distinguishable. I am non going to pose words into Lavoie's oral cavity too say that in that location is a blanket rejection of every such possibility, but I personally would fighting that they are all fairly hopeless.

Within mainstream economics, in that location is an unorthodox schoolhouse of thought known every bit the Fiscal Theory of the Price Level (FTPL - a primer). (The Lavoie text does non hash out the FTPL inward Section 8.1.1.) As Professor John Cochrane argues, if mainstream economists genuinely believed the mathematics behind their Dynamic Stochastic General Equilibrium (DSGE) models, they would terminate upward at the FTPL. The logic is sound. Unfortunately, the FTPL is an intellectual horror show: the toll grade is determined past times the discounted value of all primary financial surpluses going out on an infinite horizon. The grab is that the solely agency to mensurate the value of discounted surpluses is to assume the FTPL is true, too dorsum it out based on the observed toll level. The theory is non-falsifiable, too therefore ane could fighting that it is right (in some sense); it solely has the fry drawback that nosotros cannot brand whatsoever predictions amongst it.

We are too therefore left amongst the grab-bag of random reduced cast models that analysts amongst access to a fourth dimension serial database too econometric software lead maintain churned out. Confronted that mess of internally inconsistent models is good beyond the compass of whatsoever individual. However, I would fighting that it is prophylactic to spend upward them based on a liberate adaptation of the efficient marketplace theory: if the models genuinely were reliable, nosotros would listen nearly them.

What Works?

The message from Lavoie's text is rather scary from the perspective of anyone trying to create an inflation model (page 542):

What too therefore is the reason of the post-Keynesian theory of inflation? Post-Keynesians fighting that the 'economy is primarily a money-wage system' (Weintraub, 1978, p. 66). The coin wage is the exogenous factor [emphasis mine] explaining the toll grade that the orthodox authors lead maintain sought. As Robinson (1962, p. 70) said. 'in our model, every bit inward reality, the grade of the money-wage charge per unit of measurement obtaining at whatsoever exceptional instant is an historical accident.'

To anyone familiar amongst economist jargon, that is similar a alive manus grenade. I volition operate through the implications of that curt passage for those who are less familiar amongst academic economist-speak.

The declaration is that nominal reward are most of import (a "money-wage system"). The grab is that it is an exogenous variable -- a variable that is determined exterior the model. You cannot model the wage charge per unit of measurement inside a mathematical model, since it is an input to the model. 

So imagine that your boss tells y'all to come upward up amongst "an inflation model" for some province (which is a pretty mutual demand for employees of cardinal banks or investment firms). According to post-Keynesian theory, the "correct" respond is to respond that inflation is an historical accident**. However, I must indicate out that the theoretically right respond is also an extremely career-limiting one, therefore whatsoever employee stuck inward that exceptional province of affairs needs to figure out what their superiors desire to see, too give them just that (even if the model stinks).

Future articles volition delve farther into the post-Keynesian description of how reward relate to the measured aggregate toll level. However, the key takeaways are:

1. The human relationship betwixt reward too the CPI is complicated.
2. Wage inflation is subject upon economical institutions too convention.

In other words, make non await a cute footling regression model (or whatever) betwixt iii or iv economical fourth dimension serial too CPI inflation to work.

Aggregation Aggravation

I volition conclude amongst some other assail on reduced cast inflation models, which is based on my ain personal experience every bit an analyst than what I lead maintain seen inward the post-Keynesian literature. I lead maintain no thought how what I am writing fits inward amongst the existing academic theory. (To what extent it powerfulness tally inward amongst existing theory, it powerfulness travel to a greater extent than Austrian theory, which powerfulness crusade some of my regular readers to faint.)

I encounter real footling value inward assuming that aggregate toll levels lead maintain useful theoretical content. To travel clear, aggregate toll levels manifestly exist, too tin travel measured. (If ane rejects that they tin travel measured, ane volition lead maintain a real curt career every bit an index-linked bond analyst.) Rather, my indicate is that since nosotros are lumping together unrelated things, nosotros should non await the aggregate to follow whatsoever reduced cast model inward the start place. If nosotros are going to apply reduced cast models to inflation, nosotros would demand to apply them to the components of the CPI index separately.

Although such an assertion would give some academic economists the vapours, it would non travel a surprise to inflation-linked marketplace practitioners: that is just what they are already doing. Moreover, cardinal depository financial establishment analysts volition make such decompositions when they are preparing detailed inflation forecasts, too such cardinal bankers are mainstream almost past times definition. The number is that this approach coexists uneasily amongst mainstream theory.

We demand to forecast CPI inflation ingredient past times component.

• What volition crusade the toll of crude to move? If a cartel of crude producers determine to jack upward the global toll of oil, the domestic toll of crude volition movement amongst it (translated to local currency).
• Food commodities are also flex-price markets, driven past times varying factors. If those prices were slow to forecast, grain trading would travel an slow agency to millionaire-hood.
• Imported goods are sensitive to the central rate, which is similarly hard to forecast.
• Some prices are administered, such every bit the ever-rising cost of tuition.
• Other goods too services lead maintain varying input costs associated amongst them -- labour, rent, energy, etc.

For each of these components, the reduced cast model volition vary greatly. For example, fifty-fifty if y'all intend inflation expectations are genuinely of import for the decision of inflation, the expected CPI inflation charge per unit of measurement inward Commonwealth of Australia is going to hateful diddly squat for the global toll of oil.

Concluding Remarks

Beware reduced cast inflation models.

Footnotes:

* "Judgment" is (or at to the lowest degree was) the preferred British spelling, too is used inward Canada inward legal contexts. So it should travel fine to write the sentence "In my judgement, the judgment inward the instance was incorrect," inward a Canadian spelling test.

** North Americans would in all probability prefer "a historical accident."

(c) Brian Romanchuk 2018