Chapter 6 The theoretical foundations of

the stabilisation policy part I

Outline:

01st The three most important alternative conceptions

02nd The basic statement of the quantity theory

03rd Political conclusions

04th The criticism of the quantity theory

05th The basic statement of the demand-oriented inflation theory

06th Political conclusions

07th The criticism of the demand-oriented inflation theory

08th Basic statements of the supply-oriented inflation theory

09th Political conclusions

10th The criticism of the supply-oriented inflation theory

01st The three most important alternative conceptions

In this chapter, we want to deal with the theoretical foundations of the stabilisation policy. Three alternative conceptions are represented here:

First, the quantity theory:

According to this, inflation is mainly explained by money growth, without a corresponding equal increase in production.

Second, the demand-oriented inflation theory:

According to this theory, it is the demand surpluses on the goods markets, which cause inflation processes.

Third, the supply-oriented theory:

Here, increases in unit costs are named as the main cause of inflation.

02nd The basic statement of the quantity theory

First, let us turn to the quantity theory. Accordingly, it is mainly the increase in the circulating money supply that causes inflation. The starting point is the Fisher's equation of exchange:

The product of the money supply (G) and velocity of the money (U) is always equal to the price level (P) multiplied by the trading volume (H).

G x U = P x H

At first, this equation points only to a tautological connection. In a monetary economy, there is in principal no direct exchange of goods, goods against goods, rather money, as a general medium of exchange, conveys all barter transactions. The buyer for a good offers money, the provider of goods demands money. So, necessarily, the supply of money must correspond to the supply of goods in its sum. The supply of money and goods is only two different sides of one and the same indirect exchange and must therefore, by definition, always correspond in their sum.

If desirable, one can view the equation of exchange also as a defining equation of the velocity of money. This becomes immediately clear when the velocity in the above equation is isolated, i.e. both sides are divided by the money supply:

U = (P x H)/G

The velocity (U) indicates, in other words, how often on average a banknote conveys an act of exchange within a period.

Despite its tautological character, two partial hypotheses can be formulated on the basis of the equation of exchange:

First partial hypothesis:

If the money supply is increased, also the price level rises to the same extent. Here, it is assumed that in the short term both the velocity of circulation and the trading volume remain unaffected by this rise in the money supply:

This statement is by no means tautological and thus by no means without informative content. It applies only on the assumption that both the velocity of money and money supply variations remain unaffected and that the amount of traded goods remains constant despite increased supply of money and thus despite increased demand for goods.

So, it is these two, by no means self-evident assumptions, that support this first partial hypothesis of quantity theory. In contrast to the equation of exchange, the quantity theory is an informative and therefore falsifiable hypothesis.

The first assumption (short-term consistency of the velocity of money) is based on the observation gained by experience, that the economic subjects cultivate quite specific customs when dealing with money. At the beginning of a period, for example, wages are paid out and the cash accounts or current accounts of the employee households are filled and then these funds are spent on the purchase of goods and services only gradually.

This means that the banknotes remain in the cash registers for a certain period of time and that, for these reasons, a banknote can on average serve for fewer acts of exchange than if each economic subject would spend the collected money again immediately upon receipt. It is assumed that in a society very specific customs prevail, which hardly change in the short term and that therefore the assumption of a short-term consistency of the velocity of money is quite realistic.

Behind the second assumption, that the trade volume remains unaffected by monetary variations, there is the concept that in a functioning market economy a tendency for full employment is present, i.e. that temporary imbalances are eliminated by way of price variations, and that therefore, irrespective of very short-term changes in trading volume, all material resources, including the labour supply, are fully employed.

In this case, however, one can assume the conviction that, at least in the medium-term view, the entire supply of material resources is given and therefore cannot be changed by merely increasing the money supply. And if the market then ensures that all the offered material resources are also used (i.e. employed) in the medium-term view, one can in fact conclude that the trading volume remains unaffected by monetary variations in the short term. Here again, this is by no means a self-evident assumption. In fact, as we will see in the next section, both hypotheses have been called into question in the course of the didactic history of economics.

However, before we address this criticism, let us briefly consider the second partial hypothesis of the quantity theory. It is noted that increases in prices of goods can only ever be caused thereby that the money supply was increased also.

According to the theses of quantity theory, money growth is not only a sufficient, but also a necessary prerequisite for the occurrence of price increases. It is assumed that any increase in money supply leads to price increases and that any price increase is due to an increase in money supply. In a very stringent variant, it is even claimed that the changes in money supply and in trading volume are also completely equivalent in their extent.

This second partial hypothesis is by no means self-evident, neither. As we shall see below, this second part of the quantity theory was also criticised in the course of the didactic history of economics.

03rd Political conclusions

However, before we address this criticism of these two partial hypotheses, let us first briefly outline the political conclusions drawn from the quantity theory.

First and foremost, institutional arrangements are needed to ensure the independence of the central bank:

· A release of exchange rates is required, as the money supply is changed in exchange market interventions. In a system of fixed exchange rates, the central banks are required to keep the exchange rate stable. They achieve this aim by buying or selling foreign currency. For example, if one country has an export surplus, not all foreign exchange revenues generated by the export will be needed to pay for imports, thus creating an excess supply of foreign exchange, which would generally lead to a decline in the exchange rate. To prevent this change in exchange rates, the central bank, in a system of fixed exchange rates, has to buy these surplus foreign exchange. At the same time, however, the circulating money supply is being increased and the aim of monetary stability is endangered.

· A control of the book money creation - e.g. by a hundred per cent minimum reserve - is necessary (M. Friedman). The private banks can create deposit money and thus make it more difficult for the central bank to control the money supply. This possibility for the creation of deposit money by the private banks results from the fact that the largest part of the money granted by the bank flows back again into the bank apparatus in the form of transfers, so that these funds can be spent again as credits. However, if the private banks were obliged to have a hundred per cent minimum reserve - which is demanded by Friedman - this danger would be averted, and the central banks would again have sufficient control over the circulating money supply.

· The monetary expansion must be aligned with long-term growth. The attempt of the central banks to stabilise the economic cycle by a stop-and-go policy increases the uncertainty of long-term investments and prevents a sufficient investment activity which is required for full employment just on this way. Therefore, Friedman demanded that the central banks should refrain from controlling the economic situation and that the money supply should be aligned with the long-term growth of the domestic product in order to ensure the stability of the monetary value.

· According to this theory, it should be refrained from direct interventions in the goods markets and labour markets, too. The attempt of the state to avoid price increases by direct state interventions in the goods markets and labour markets and by setting price ceilings respectively wage ceilings, impedes on the one hand the reduction of imbalances, since in a market economy, this reduction is eventually realised mainly due to price variations. On the other hand, such a policy contributes to perpetuate scarcities. Price increases ultimately contribute to increase the supply and thus to reduce the scarcity.

04th The criticism of the quantity theory

Criticism of quantity theory was raised primarily by John Maynard Keynes.

Firstly, the velocity of money is not constant even in the short term:

According to Keynes, it must be distinguished between the transaction motive and the speculative motive of the cash management. According to the transaction motive, the demand for cash depends on the income level; it rises with growing income. If, for example, the income doubles, then the amount of money, which is on average in the coffers of households and enterprises, ceteris paribus should also have doubled approximately. However, this shows that the velocity of money is indeed subject to short-term fluctuations and that it changes with the economic development of incomes.

According to the speculative motive, the demand for money depends on the amount of interest; with low interest rates, a quick rise in interest rates is expected and therefore money is kept in register temporarily. Therefore, also short-term changes in the cash balance result and thus also in the velocity of money depending on changes in the interest rate.

Secondly, a monetary expansion leads - in the view of Keynes - very well to an expansion of production. It cannot be expected that all workers will always be fully employed, and production capacity will be fully utilised. Especially, a non-functioning capital market prevented a balance between supply and demand. The interest mechanism was disenabled, as parts of the savings are kept in register and thus are not offered on the capital market. In this case, however, despite an excess of the savings over the investment amount, there is no interest rate cut.

But even if the interest rate decreased in the event of a decline in the economy, secondly, the fall in the interest rate would not be enough to induce entrepreneurs to increase their investment. Because of the still remaining surplus capacity, the entrepreneurs are not willing to expand their production capacity, which is already not fully utilised in this economic phase.

Also, the interest cost reductions would not benefit the entrepreneurs at all, because cost reductions would have to be passed on immediately in the form of price cuts to consumers due to a lack of consumer demand during the economic downturn and the hereby resulting strong competition.

However, this criticism is not convincing. There are not only expansion investments, but also rationalisation investments. It may be true that in times of recession, entrepreneurs do not expand their production capacity, even when interest rates fall. But it is precisely the intensified competition in times of recession that forces entrepreneurs to reduce costs by help of rationalisation investments. Indeed, it must be expected that there will be a labour-saving technical progress and thus even workplaces are rationalised in this way.

Whether this is the case, however, depends crucially on the wage-interest ratio. There is always a wage-interest relation that enables full employment. If, on balance, jobs are eliminated nevertheless, then this is due to a failed interest rate policy, in which the interest rate is pushed below the equilibrium interest rate by the central bank or because of a failed wage policy by the unions, to raise the wage rate above the marginal productivity of labour.

Regardless of the Keynesian criticism of the quantity theory, the latest developments of the recent years gave rise to doubts on the theses of this theory. Has the money supply not been expanded even on a very large scale and has the general price level not remained largely constant over the same period? Is this not a clear refutation of the quantity theory in this development?

To answer this question, we need to get clear about why, despite enormous monetary growth, the price level of goods has remained constant during this time. If we take Fisher's equation as a basis - which is always correct by definition - the price level of goods will only remain unchanged at an increase of the money supply, if at the same time goods production has increased to the same extent as the money supply or if the velocity of money has declined during this time. A third possibility is not possible because of the tautological relationship of Fisher's equation of exchange (M * U = P * X).

Now for the period in question, the domestic product has not been raised - or at least not to the extent of money supply. Thus, the far-reaching constancy in the price level of goods can only be explained by the fact that the velocity of money has declined strongly in this period.

In fact, this was also the case. For a long time, the commercial banks had mutually borrowed the unused cash reserves and thereby contributed to a decisive increase in the velocity of money. Through these reciprocal provision of surplus cash reserves, market transactions could indeed be extended without individual banks having additionally incurred indebtedness with the central bank.

Due to the past financial crisis, the mutual trust of the banks among each other has been weakened decisively with the consequence that the willingness to lend each other unused cash reserves has been drastically reduced. With this decline, however, the velocity of money also decreased automatically.

At the same time, the confidence in the economy could not be increased despite the enormous expansion of the circulating money supply by the central bank. The additional money was thus not used for the purchase of goods, especially of capital goods, but either remained on the money market accounts according to the Keynesian liquidity theory or was used for the purchase of gold or real estate.

Therewith, the prerequisites for fulfilling the relationships asserted in the theory of quantity remained missing. According to the quantity theory, an expansion of the money supply leads to price increases only if the additional money supply is used to exert more demand for goods. But if the demand for goods increases, without the supply of goods being increased as well, the price of goods must rise in accordance with general market laws. Because the increase in demand for goods failed to appear despite an increase in the amount of money in the recent past, the price increases asserted by the quantity theory did not occur.

An important assumption of the quantity theory was therefore in reality not fulfilled in the recent past. But was the quantity theory thereby falsified already? From a formal point of view, one can draw this conclusion, of course. Nevertheless, the following consideration speaks against this conclusion.

The quantity theory claims that the velocity of money remains constant in the short term, as quite specific behaviours in dealing with money had established in the past. And this thesis also corresponded to reality in the past. The quantity theory has never claimed that a long-term change in velocity of money is impossible. Therefore, it does not contradict the basic statements of this theory either, if the velocity of money has changed in the long run.

The severity of the past financial crisis has indeed led to a huge crisis of confidence such that the velocity of money has been reduced. There is little evidence, however, that the velocity of money has now been reduced for a long time necessarily. On the contrary, it can be assumed that by overcoming the long-term effects of this financial crisis, the reciprocal confidence of the banks in each other returns, and thus the velocity of money rises again to its former level due to the mutual borrowing of money reserves. The prerequisite for this, however, is that policymakers carry out fundamental reforms of the banking sector, thereby preventing or making it less likely that further general financial crises of the previous magnitude occur.

However, of the statement of the inflationary effects of a monetary supply increase remains that, when the money created in the past is someday used for the purchase of goods, then the price level of goods will rise strongly, unless it is achieved that the production of goods is increased to the same extent in a short time, or if the central bank is unable or unwilling to remove this excess of money from the circulation.

But just in this respect the possibilities of the central bank are limited. So far as the past increase in the money supply has been made by the purchase of the ailing securities, the central bank lacks a large part of the funds for a drastic contractionary monetary policy. This would presuppose that the central bank discharges securities again and thus withdraws money, which presupposes, though, that the securities present in the portfolio of the central bank are not ailing and therefore not unsellable.

Furthermore, it is to be feared that the central bank will miss the time of the transition to a contractionary monetary policy. A cyclical upswing is indeed not synchronous in all economic sectors, some rush ahead, others follow with great delay. Therefore, there is a risk that in some sectors, prices may already rise strongly due to full capacity and cause an increase in the inflation rate, while in other sectors unemployment still prevails.

If, as a result of this partial unemployment, the central bank is unable politically to turn things around and start a contractionary monetary policy, then the surplus money created in the past will definitely have price increasing effects one day.

05th The basic statement of the demand-oriented inflation theory

Let us now turn to demand-oriented inflation theory. It is part of the Keynesian approach. While it is obviously proper that Keynes himself has dealt very little with the question of what the determinants of inflation processes are. For Keynes, it was not monetary stability that was under consideration, but rather the process of depression, that is opposed to the economic cycle, and the problem of mass unemployment.

In fact, after overcoming inflation in the immediate period after the First World War, monetary stability was no more threatened for a long time, but it had to be assumed that in the Great Depression - beginning in the late twenties of the 20th century - mass unemployment and its overcoming became the main problems of the states.

If we can nevertheless speak of a Keynesian theory of inflation, then it is because the thinking tool that Keynes created with his macroeconomic theory was applied to inflationary problems in the period after the Second World War and thus developed beyond Keynes.

After all, in his basic work - published in the year 1930 - "The general theory of employment, interest and money" Keynes had talked about a general theory, which had been primarily concerned the analysis of employment, but included at least also the money and its relationships in his analysis.

Keynesian approaches are now used in demand-oriented inflation theory primarily thereby that, on the one hand, market processes, in contrast to the classical theory, are not determined by the supply factors but by the demand factors and that, on the other hand, in the scope of the equilibrium process price variations are less decisive than quantity variations, which ultimately lead to an equilibrium in the goods markets and capital markets.

In the context of Keynesian theory, it is often simplistically assumed that production capacity is underutilised during the recession and the beginning of the upswing, so that demand increases lead to an equally large increase in production at relatively constant prices in a relatively short time. If all production capacities are utilised to a large extent in times of economic boom and nevertheless the demand increases, then these increases are only reflected in price increases.

In reality, we have to expect that between these two extreme situations (initially only volume growth at constant prices, then immediately price increases at a constant volume) pushes an interim period, in which partially the goods quantities rise still while already partly the goods prices rise.

This development (both price and volume growth at the same time) has mainly two different causes. On the one hand, in production theory we mostly assume production functions in which the marginal and unit costs rise, at least from a certain critical production quantity on. Enterprises will always try to pass on these cost increases to the price of goods.

On the other hand, the cyclical upturn in the various sectors of the economy is not synchronised, individual sectors are rushing ahead and also having faster production growth, and just therefore they reach the full utilisation of production capacity much earlier than the other industrial sectors, while other industrial sectors lag behind and remain with free production capacity for a long time when other industrial sectors are already fully utilised.

The consequence of such a different (asynchronous) development of production is that price increases take place in individual industrial sectors already in times when greater unemployment prevails still in other industrial sectors. This explains the interim period in which price and volume increases take place at the same time.

And it is evident that an economic policy that relies solely or only predominantly on influencing macroeconomic variables, gets into great difficulties, since then it would have to accelerate and brake at the same time. But both is not possible at the same time, however, if one limits oneself to macroeconomic control processes.

We can capture this development (at first only volume growths, then increases in volumes and prices and finally only price increases) in the following graph. The abscissa shows the production volume (x) whereas the ordinate shows the overall economic price level (p).

Thus, while Keynes himself has dealt with the first phase, in which price increases can be ignored, Keynesians, like especially Kaldor in the 1950s, attempted, due to the partially strong inflationary processes, to turn Keynesian theory into a general macroeconomic theory, also including inflationary processes.

The starting point of this theory is therefore an overemployment situation. It is assumed that the price level (p) increases always when excess demands arise, whereat the extent of the price increase is corresponding to the extent of the demand surplus.

Of course, this assumption does not constitute scientific innovation. Also, Neoclassical economics has always been based on the assumption that excess demands are reflected in price increases. This applies initially to each single market, but precisely for this reason for macroeconomic variables, too.

What is new about the demand-driven inflation theory, however, is the assumption that these price increases are not able to reduce excess demands. The Neoclassical economics was convinced that in the normal case price increases are quite able to reduce the excess demands by the fact that usually both supply increases and demand reductions emanate from price increases, so that the market imbalance is reduced from two sides automatically, this means also without the need for political intervention.

Only when supply and demand are completely inelastic, or when supply and demand are even abnormally responsive to price variations, that is, when price increases respond with a reduction in production volumes and an increase in demand, then the equilibrium mechanism of the market does fail.

Now, what is the reason why Keynesians are assuming that general price increases are not able to reduce excess demand? The true reason for this lack of effect do Keynesians see in the circle correlations. Namely, if prices rise in general, then incomes rise to the same extent, too.

The thesis that price increases lead to a reduction in demand, applies namely only under the ceteris paribus clause that only the price of goods rises, but the incomes do not rise simultaneously. At the increase in incomes, it is assumed at normal reactions that the demand for goods increases. Thus, the partial decline in the demand for goods due to the price increases is offset thereby that at the same time demand is partially rising due to income increases. Therefore, both effects cancel each other out.

From a microeconomic point of view, this cycle effect could be disregarded now, since the income effect is small compared to the price effect. If e.g. the price of a car increases by 10% and therefore the employees of these enterprises earn a higher income, then increases the demand effect due to the income effect only for the employees who are employed in this sector. The price effect, on the other hand, is due to the reaction of all consumers, because all consumers of this good are affected by this price increase.

However, if one turns to a macroeconomic analysis, both effects (price and income effect) relate to the entire economy, are therefore about the same size and thus cannot be neglected.

The market forces are therefore - following the Keynesian view - not able to reduce excess demand by price cuts in a macroeconomic perspective. We can clarify these relationships in a graph again, we draw on the abscissa the macroeconomically supplied and demanded production quantity (X), and on the ordinate the aggregate price level (p):

Initially, we consider the red line of supply. By definition, the respective size of the ordinate corresponds to the size of the abscissa. In both cases, the value of the offered production quantity is measured. However, for the demand curve plotted in blue applies the general assumption of any Keynesian theory that the propensity to consume is less than one, thus an increase in income leads to an increase in demand, but this additional demand is always less than the income growth that has triggered the increase in demand.

Since the gradient of the supply line is 1, but the demand curve is less than one, both curves intersect at a certain point (x_g), thus at which the goods market is in equilibrium.

The decisive factor is now that the price level of goods does not enter the supply or demand curve as a determinant, so that the position of both curves and thereby naturally the intersection of both curves with price variations is not postponed. If we assume a market imbalance (about x₁), the price level is assumed to rise, but the excess demand will not be reduced.

However, to make these price increases possible at all in the event of macroeconomic excess demand, also the assumption of

· a completely elastic money supply and / or

· a completely elastic liquidity preference

must be made.

According to the equation of exchange, which by definition is always valid (also in Keynesian theory), price increases at a permanent quantity of goods (production capacities are exhausted!) can only be supported by either an according increase of the money supply and / or the velocity of money. In this context, it is reasonable that Keynesian fiscal policy must be accompanied by an expansive monetary policy of the central bank in order to prevent the growth in government spending by way of interest rate increases from leading to a decline in the private demand (so called crowding out).

To be continued!