Sunday, March 19, 2017

Latin American corner: Neo Fisherism, New Keynesianism and monetary policy in Latin America (II)

By Naked Keynes (Anonymous Guest Blogger)

The positive relationship between nominal interest rates and inflation is not a new stylized fact in economic theory. In the 19th Century Thomas Tooke (1774-1858) considered it a general rule illustrated by the data presented in his History of Prices and the State of Circulation, 1792-1856 (published over the period 1838-1857).

Tooke rationalized the positive relationship between inflation and interest rates by postulating that the interest rate is part of the cost of production of commodities As a result when interest rates rise so does the cost of production and hence prices. As he put it in his Inquiry into the Currency Principle (1959 (1844) p.81: “A general reduction in the rate of interest is equivalent to or rather constitutes a diminution in the cost of production…the diminished cost of production hence arising would…inevitably cause a fall of prices of all the articles into the cost of which the interest of money entered as an ingredient.” Tooke dismissed the existence of a negative relation between interest rates and commodity prices. A fall in interest rates may be synonymous with liquidity but as Tooke remarked (Ibid, p.79):“A power of purchase might thus doubtless be created; but why should it be directed to the purchase of commodities if there was nothing in the state of supply, relatively to the rate of consumption, to afford the prospect of gain on the necessary eventual resale?..The error is in supposing the disposition or will to be co-existence with the power. The limit to the motive for the exercise of the power is in the prospect of resale with a profit.” By the way the assumption of equating the disposition with the power of purchase is a fundamental tacit assumption underlying the monetarist, New-Classical and New Keynesian monetary transmission mechanisms. It´s the whole story behind real cash balances and the transactions demand for money. Tooke went further he assimilated the effect on interest rates on asset markets (Ibid, p.86):“A low rate of interest is almost synonymous with a high price of securities…”

Tooke´s views were challenged by Knut Wicksell (1851-1926): “Tooke´s thesis is certainly wrong…The argument is based on the inadmissible, not to say impossible, assumption that wages and rent would at the same time remain constant, whereas in reality a lowering of the rate of interest is equivalent to a raising of the shares of the other factors of production in the product” (Wicksell, Lectures on Political Economy, II, p. 183). Wicksell´s criticism of Tooke and his disciples led him to explain the rise in prices and inflation by the gap between the natural rate of interest (“the rate of interest at which the demand for loan capital and the supply of savings exactly agree”, Ibid, p. 193 and which depends on real as opposed to monetary factors including “the efficiency of production…the available amount of fixed and liquid capital, on the supply of labour and land…” Wicksell, Interest and Prices (1936 (1898) p. 106)) and the money rate of interest. Assuming full employment, a pure credit system and that banks respond endogenously to the demand for credit Wicksell showed that when the natural rate of interest exceeded the money rate of interest an inflationary process ensued. The inflationary process led eventually to an increase in the money rate of interest to match the natural rate of interest at which point inflation would stop. In this way Wicksell was able to resurrect the positive relation between the money rate of interest and inflation while rejecting Tooke´s theses.

The Wicksellian distinction between the natural and money rate of interest is at the heart of the New Keynesian model. It appears in the aggregate demand equation (IS) and in the Taylor rule and in fact the Central Banks that have explicit inflation targeting regimes (as well as some that do not) must obtain estimates of the natural rate for their models to be operative. Without the natural rate there would be no New Keynesian monetary models. However, it is odd, that the relation they postulate between the money rate of interest and inflation is exactly opposite to that of Wicksell.

Needless to say, New Keynesian inflation targeting models do not have scope or space to include the type of causality between interest rate and asset markets envisage by Tooke (which is an essential component of Keynesian economics). These models do not include the banking system or asset markets. This is due to their firm commitment to the upgraded “divine coincidence”: price stability (equating the market and natural rate) is equivalent to full employment and to financial market stability.

To be continued

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