September 5, 2015

Deflation? Oops, price theory, too, is wrong

Comment on ‘Deflation and Money’


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 claims.

The correct formula for the market-clearing price in the simplified consumption good industry is shown on Wikimedia AXEC41

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 consumer goods industry. The formula follows from (2014, Sec. 5). The more differentiated and therefore better testable formula is given on Wikimedia AXEC39

The crucial message is that the wage rate is the 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 formula kept constant for the moment).

For the rectification of the naive quantity theory see (2011) (I)/(II).

Egmont Kakarot-Handtke

Kakarot-Handtke, E. (2011). Reconstructing the Quantity Theory (I). SSRN Working Paper Series, 1895268: 1–28. URL
Kakarot-Handtke, E. (2014). The Three Fatal Mistakes of Yesterday Economics: Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL

ICYMI (September 7)

Economists still do not understand how the price mechanism works. No surprise after endless repetition of the silly supply-demand-equilibrium model. The pivotal relationship is given by the relative changes of average price/wage/productivity. These changes should secure full employment if standard price theory were correct. It never was. The current unemployment/deflation situation is the mirror image of the unemployment/inflation situation of the ’70s. After New Classicals and New Keynesians have long enough fooled around it is now high time to finally solve the Phillips curve puzzle. See Keynes’s Employment Function and the Gratuitous Phillips Curve Disaster.

The effective alternative to monetary and fiscal policy fixes is to put the price mechanism to work.