September 8, 2015

Lack of understanding

Comment on ‘Revealed Preferences: Fed Inflation Target Edition’


You quote: “A recent Wall Street Journal article reporting from the Jackson Hole Fed meetings led with this opening sentence: ‘central bankers aren't sure they understand how inflation works anymore’."

The fact of the matter is that central bankers never really understood inflation. This was not a problem, however, as long as their naive quantity theory seemed to work. We know from the history of science that false theories — e.g. Aristotle’s theory of motion — work satisfactorily in everyday situations. Most of the time the falseness of false theories is invisible to the naked eye.

The current economic situation is a clear refutation of both commonplace employment and quantity theory. The core of the unemployment/deflation problem is that the price mechanism does not work as standard economics suggests.

This theory failure cannot be overcome by speculation about the Fed’s motives. This second-guessing invariably ends with the aha-insight ‘they’ serve themselves or their buddies.

This misplaced psychologism obviously cannot explain inflation/deflation. Science works differently. The correct formula for the market clearing price in the simplified consumption good industry is given here.

Roughly, the formula says that the consumer price index declines if (i) the average expenditure ratio falls, (ii) the wage rate falls, (iii) the productivity increases, and (iv) the employment in the investment good industry shrinks relative to the employment in the consumption goods industry. The formula follows from (2014, Sec. 5).

The crucial message is that the wage rate is the nominal numéraire of the price system. If at all, the quantity of money plays an indirect role via the expenditure ratio and the employment relation of the investment good and the consumption good industry.

The rule of thumb says: if wage increases for the business sector as a whole lag behind productivity increases deflation occurs (the rest of the price formula kept constant).

Science is not about producing pointless behavioral speculation but about producing testable systemic laws. This is how economists could really help the clueless Fed to understand inflation/deflation better.

Egmont Kakarot-Handtke

Kakarot-Handtke, E. (2014). The Three Fatal Mistakes of Yesterday Economics: Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL