sábado, 7 de junho de 2008

On The Impact of Demand Shocks on Inflation

On The Impact of Demand Shocks on Inflation
Franklin Serrano (Instituto de Economia, Federal University of Rio de Janeiro, Brazil)
Joan Robinson (1982) liked to tell the story that Kalecki once defined orthodox economics as “the science of confusing stocks with flows”. Nowadays in discussions about fighting inflation it seems that it is more about confusing levels, rates of increase and acceleration. Here we are concerned with a single question (for more details see Serrano, 2007): What is the impact of a demand shock on prices? Does it increase the price level, causes a positive rate of inflation or does it accelerate permanently the rate of inflation?
After Friedman and Phelps most people think that usually a single aggregate demand shock, which for our purpose we shall define as something that generates a positive output gap leads to a permanent acceleration of inflation, that is a step increase in the rate of inflation.
Formally, p being the current proportionate rate of increase of the price level , u being the ratio of actual output to capacity output (or employment to capacity employment) and and b a parameter we would have:
p-p-1= b(u-1)
It is not very clear why people think that way since there is overwhelming statistical evidence that almost everywhere in the world inflation persistence coefficients add up to less than one at least since great moderation of the early nineteen eighties in the rich countries and since the mid nineteen nineties in most of the periphery.
Now if they do add to less than one (in Brazil the highest estimate I have seen is 0.6) the impact of a single demand shock cannot be fully persistent. Therefore the impact of a single demand shock is on the level of inflation and not on its acceleration.
Formally, let a be the coefficient of lagged inflation p-1 (for simplicity we assume a one period lag only) . We then have:
p = b(u-1)+ a p-1
that will quickly tend to :
p = b(u-1)/(1- a)
which means that inflation will tend to zero as soon as the demand shock is over and the output gap is closed.
Does that mean then that demand shocks cause a level effect on inflation rather than its acceleration, like in the days of good old Phillips curve ?
Well, not really. As it happens, there is another thing. There is a large amount of statistical evidence which shows that the rate of capacity utilization and the rate of unemployment tend to be mean reversing (the former much more certainly and quickly than the former) . However there is a bigger amount of statistical evidence that the levels of output and employment exhibit strong or full hysteresis , which means that whatever causes their cycles is also what causes their trends or to put it in the words of someone who already knew that many decades ago “In fact, the long run trend is but a slowly changing component of a chain of short-period situations: it has no independent existence”(Kalecki, 1968, section I).
Ok, but so what ? The thing is that this overwhelming evidence of strong hysteresis shows that any increase in output (or employment) that is sufficiently persistence will bring wih it an endogenous increase in the levels of potential or capacity output (and employment). If and when this happens the output gap will close itself, not by a decrease in the growth of aggregate demand but by an induced increase in the growth of aggregate supply (as it is explained in models of flexible accelerator induced investment such as my own supermultiplier).
Note that every single econometric model that uses the now trendy (no punt implied) statistical filters to measure the output gap will exhibit these strong hysteresis effects on potential output.
But if we take these two pieces of statistical evidence together (on which see Braga,2006), i.e., the partial persistence of inflation and the strong hysteresis of potential output, the total long run impact of a permanent demand shock will be first a temporary level effect on the rate of inflation that will not last , even if demand growth is not checked , because later the level of potential output will catch up with the higher levels of demand and the output gap will close. When this happens the gap falls back to zero and there is no more demand inflation. In the end, the permanent impact of the demand shock will have been just a permanent increase in the price level. Note that is the sole long run effect of demand on inflation even for places where it is easy to find a significant impact of the demand shock variable on Phillips curves , which by the way is definitely not the case of Brazil (Serrano,2008).
Braga, J. “Raiz unitária, inércia e histerese: o debate sobre as mudanças da NAIRU na economia americana nos anos 1990”, IE-UFRJ, Ph.D. dissertation
Kalecki, M. “Trend and Cycle”, Economic Journal, 1968
Robinson, J. “Shedding darkness”, Cambridge. Journal of economics”,1982; 6: 295-296
Serrano, F. (2006). “Mind the gap: hysteresis, inflation dynamics and the sraffian supermultiplier” IE-UFRJ, mimeo
Serrano, F (2008) “Juros, câmbio e o sistema de metas de inflação no Brasil”, IE-UFRJ, mimeo

terça-feira, 1 de maio de 2007


by franklin serrano

In a recent issue of the Cambridge Journal of economics[ NOV. 2006] there is a debate between my friend Sergio Cesaratto and Tom Michl concerning the possible long run effects on capital accumulation of a fall in current consumption (in the case under discussion following some kind of pension reform that cuts benefits or increases contributions). Michl, echoing and older argument by Paul Krugman (1997) against what Krugman called the Vulgar Keynesians, complains that Cesaratto´s negative conclusion gives too much importance to the paradox of thrift, which would not be relevant in the long run in an economy in which the central bank runs an anti-cyclical policy. I think this is a very important discussion because more and more heterodox (and even leftist) economists think we should be "Keynesian in the short run and Classical in the long run". Since Cesaratto and I hold the opposite view that we should be Classsical and Keynesian in the long run (even long run growth is usually demand-led)

The argument of Michl and also of Krugman can be summarised as follows:
given that:
1. aggregate demand is interest elastic (lower interest rates
increase aggregate spending)
2. The fed controls interest rates
3. The fed has a target for the unemployment rate (its view, real
or imagined, of the NAIRU)

From these three assumptions they conclude that, at least for the U.S. were the fed does actively cut interest rates when unemployment is seen to be too high, the paradox of thrift is irrelevant. an increase in the marginal propensity to save will increase investment. Giving up consumption today (of current capacity output) willl lead to higher levels of consumption in the future (of future capacity output).
Krugman accuses Jamie Galbrath and Michl accuses Cesaratto of not
seeing that we cannot accept premises 1,2 and 3 and deny the inevitable conclusion. That is what Krugman calls Vulgar Keynesians.
I cannot speak for Jamie Galbraith or the post keynesians but no such incoherence is to be found in the demand led sraffians (such as cesaratto and myself). Our assumptions are slightly different. And this leads to a very different conclusion.

The crucial point of the Sraffians is that productive investment, i.e., investment that generates productive capacity for the private sector of the economy for a number of theoretical and empirical reasons is NOT interest elastic [Check Fabio Petri´s 2005 book].
In other words, by lowering interest rates the fed does NOT directly increase non residential investment. Non residential, productive investment is driven by expected and (over a longer run) actual evolution of effective demand.
Now, this being the case, aggregate demand only respond to reductions and/or lower
levels of interest rates through their effects on unproductive expenditures, i.e., those that do not increase the productive capacity of the private sector (namely housing "investment" and consumption of durables).
Therefore we may say that the Sraffians would in principle accept a modified form of
assumption 1 above:

1a- Aggregate demand is interest elastic but only through the interest
elasticity of consumption or unproductive expenditures

Now, if we put together assumptions 1a, 2 and 3 what would be the effect of an increase in the marginal propensity to save? Initially current consumption would fall . This would cause unemployment to increase. Then the fed would start cutting interest rates. This would make consumption and housing demand increase until aggregate demand went back to its former level.
What is the long run effect of that? productive (non -residential) investment does NOT change at all since in the end aggregate demand is exactly what was before.
Therefore a desire to cut present consumption , presumably in order
to increase future consumption, in the long run leads to no fall in current aggregate consumption whatsoever, no change in productive investment and therefore no increase in future consumption.
The correct conclusion is that is there is simply no way an economy in which productive investment is not interest elastic can increase future consumption by foregoing present consumption through "capital deepening", even if the fed adopts an efficient counter cyclical policy.
We have assumed that consumption and residential investment are regularly interest elastic which sometimes may not be the case. But note that even if they were not we could still reach the same conclusions through fiscal policy. If the government runs a perfect countercyclical policy cutting taxes and increasing consumption to the
extent necessary to bring aggregate demand and unemployment back to
its former level, the result is the same. A cut in current consumption leads to an offsetting increase in...current consumption.
Even if we believed in the old pigou or real balance effect (which of course does not work with the fed pegging interest rates) the same conclusion would follow. A fall in the induced consumption would be offset by an increase in autonomous consumption with no permanent change in either aggregate demand or productive investment.
When Cesaratto replies to Michl that given an increase in the marginal propensity to save at most the anti cyclical policy would bring the economy back to its previous situation with no change in productive investment and capacity growth he is absolutely right.
And prof. Krugman is indeed "missing something" : the distinction between an interest elastic aggregate demand and an interest elastic non residential investment function. In the U.S. economy, the former seems to be less regular and stable than he thinks and the latter is nowhere to be found. Capital deepening and the natural rate of interest do not exist.

quinta-feira, 11 de janeiro de 2007


The purpose of this blog is to be a forum for discussing political economy issues in the tradition of Piero Sraffa and Mikhail Kalecki.