Comment on Stanley Fischer’s speech* on ‘(Money), Interest and Prices: Patinkin and Woodford’

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Wicksell came after Jevons, Menger, Walras and stands in the long orthodox line which has actually morphed into DSGE. He has become famous for establishing the relationship between the rate of interest and the price level. His basic idea re-emerges in the actual contributions of Woodford and goes as follows.

“At any moment ... there is a certain level of the average rate of interest which is such that the general level of prices has no tendency to move either upwards or downwards. This we call the normal rate of interest. Its magnitude is determined by the current level of the natural capital rate, and rises and falls with it.” (See speech)

All variants of Orthodoxy are built upon this set of foundational propositions, a.k.a. axioms: “HC1 economic agents have preferences over outcomes; HC2 agents individually optimize subject to constraints; HC3 agent choice is manifest in interrelated markets; HC4 agents have full relevant knowledge; HC5 observable outcomes are coordinated, and must be discussed with reference to equilibrium states.” (Weintraub, 1985, p. 147)

Methodologically, these premises are forever unacceptable but the representative economist swallows them hook, line and sinker since more than 140 years. NOT ONE of the axioms holds water. Today, the failure of the Walrasian program as embodied in HC1|HC5 is indisputable. Strictly speaking, the microfoundations approach has already been dead in the cradle 140 years ago.

Consequently, what has to be done is to fully replace HC1|HC5. The paradigm shift from subjective-behavioral microfoundations to objective-structural macrofoundations is achieved as follows.

(A0) The objectively given and most elementary configuration of the (world-) 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.

For the graphical representation of the ABSOLUTE STRUCTURAL MINIMUM see link #1. A1 to A3 asserts: At any given level of employment L, the wage income Yw that is generated in the consolidated business sector follows by multiplication with the wage rate W. On the real side, output O follows by multiplication with the productivity R. Finally, the price P follows as the dependent variable under the ADDED preliminary conditions of (i) budget balancing, i.e. C=Yw, and (ii), market clearing, i.e. X=O.

Under the conditions (i)|(ii) the price is derived in each period as P=W/R (1), i.e. the market clearing price is in the most elementary case equal to unit wage costs. This is the simplest form of the Law of Supply and Demand. It holds for the economy as a WHOLE.

The first point to notice is that the real wage W/P is invariably equal to the productivity R according to (1). The second point to notice is that monetary profit, i.e. Qm=C-Yw, in the most elementary case of the pure consumption economy is zero because of (i). For profit/loss to emerge this condition has to be lifted.

Note that the product market is cleared due to condition (ii), and it has been left open so far HOW this is done in practical detail. These details are not needed at the moment.

In a paraphrase of Wicksell, the summary is: ‘In any period there is, given an arbitrary change of (average) productivity R, a certain change of the (average) wage rate W which is such that the general level of prices P has no tendency to move either upwards or downwards.’

Inflation results if the rate of change of the wage rate is CONTINUALLY above the rate of change of productivity. Deflation results in the opposite case. In the pure consumption economy as given by A1|A3 and the conditions (i)|(ii) inflation/deflation has nothing at all to do with the rate of interest. Transaction money is elastically provided by the central bank (2011), so the quantity of money plays a passive role.

For the investment economy, A1 to A3 have simply to be differentiated. The formula for the market clearing price is then given with #2. Legend Pc: market clearing price for the consumption good industry, rhoE: expenditure ratio, W: (average) wage rate, Rc: productivity in the consumption good industry, Li: employment in the investment good industry, Lc: employment in the consumption good industry.

The purely structural formula says: if (under the condition of the usual negative elasticity) the rate of interest goes down and investment and with it Li goes up, then Pc goes up. This is the Wicksell price effect of an interest rate change. However, if in the next period the interest rate remains on the lower level, Li remains on the higher level, that is, there is NO further price change and NO inflation.

Now, we combine the Wicksell effect, i.e. rate of interest down and Li up, with wage rate W down. If the second effect is stronger, then Pc is DOWN, that is, the Wicksell effect is swamped. Hence, if the wage rate changes remain continually behind productivity growth one gets deflation. This is what can be observed at the moment.

Now, the problem is this: monetary policy, i.e. the stabilization of the value of money, depends on a strong and reliable Wicksell effect. The central bank can control the rate of interest but not the wage rate. Therefore, central bank policy is ineffective (i) at the zero lower bound, and (ii), if the wage rate/productivity effect swamps the Wicksell effect.

In the current situation, the Fed cannot achieve the 2 percent inflation objective. This has nothing at all to do with expectations or forward guidance or other Woodfordian psycho gimmicks. The one and only effective measure is to increase the average wage rate. And this is beyond the competence of any central bank.

Conclusion: The neo-Wicksellian/Woodfordian approach to macroeconomics is beside the point because it lacks the correct macrofoundations. With DSGE, current monetary policy has no sound theoretical foundation.

Egmont Kakarot-Handtke

References

Kakarot-Handtke, E. (2011). Reconstructing the Quantity Theory (I). SSRN Working Paper Series, 1895268: 1–28. URL

Weintraub, E. R. (1985). Joan Robinson’s Critique of Equilibrium: An Appraisal. American Economic Review, Papers and Proceedings, 75(2): 146–149. URL

* Speech

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