Sunday, 28 November 2010

The Unanswered Questions of Modern Monetary Theory #1 - Does the Economy Price adjust?

Modern Monetary Theory advances an idea that appeals to my accountant's head. It is 'stock-flow' consistent with the rules of accountancy and it sits well with the available evidence out there.

But as with all philosophies there appear to be assumptions, and practitioners of the philosophy often struggle to see them. Now this might be because the pupil (ie me) doesn't understand something, or it may be that the evidence hasn't been made clear. Hopefully it is not a logical leap of faith. This series is to get answers to questions I have yet to get resolved to my satisfaction.

My first unanswered question is one that gets to the meat of inflation.

From Money neutrality – another ideological contrivance by the conservatives which includes a good demolition of the Quantity Theory of Money.

The overwhelming evidence is that the macroeconomy quantity adjusts rather than price adjusts to nominal aggregate demand fluctuations when there is excess capacity. Otherwise firms risk losing market share.

So, when the economy is in a state of low capacity utilisation with significant stocks of idle productive resources (of all types) then it is highly unlikely that the firm will respond to a positive demand impulse by putting up prices (above the level that they were before the downturn began). They might stop offering fire sale prices but that is not what we are talking about here.

This should discourage you from automatically linking growth in the monetary base and inflation. There is no link.

So the first unanswered question is:

What 'overwhelming evidence' shows that the economy does indeed demand adjust in preference to price adjusting?