Fiscal policy vs monetary policy to control inflation: MMT perspective, by Joseph Laliberté

In the comment section of a previous post, I suggested that Modern Monetary Theory (MMT) was a form of "quantity theory", and that it would be to MMT's advantage to develop on this point. The following is an excellent piece on this topic by fellow blogger Joseph Laliberté. This article is cross-posted in French on Joseph's blog, Défricher l'économie.

Scott Fullwiller once pointed out that MMT is also a quantity-theoretic model of changes in the price level:

Interestingly, MMT is also a quantity-theoretic model of changes in the price level. The differences are (1) net financial assets of the non-government sector, rather than traditional monetary aggregates, is MMT's preferred measure of “money,” and (2) desired leveraging of the non-government sector is akin to what one might call “velocity.” In MMT, the two of those together (net financial assets of the non-government sector relative to leveraging of existing income) set aggregate demand and ultimately changes in the price level, at least the changes that are demand-driven.

Net financial assets of the non-government sector are equivalent to past accumulated government deficits (a government deficit is a surplus for the non-governmental sector, see here for the accounting demonstration). As per MMT formulation, we have: (I think Warren Mosler was the first to come up with the MMT interpretation to this famous economic equation)

1) M*V = P*Q

Where M is net financial assets of the non-government sector and V is the desired leveraging of the non-government sector (V could also be seen as the inverse of the desire to save of the non-governmental sector); P is the price level and Q is the output.

Assuming that the economy is operating at capacity (denoted by Q’) at a given price level (P’), any increase in M or V would be inflationary (i.e. would increase the price level beyond P’). Therefore, if the government decides to increase net financial assets of the non-governmental sector by running a deficit, in such scenario, inflation would result. However, mainstream economics would argue that the increase in net financial assets of the government sector need not be inflationary to the extent that the Central Bank could influence the desired leveraging of the non-governmental sector (denoted by V) by manipulating the interest rate. In a nutshell, the Central Bank could offset the inflationary effect of an increase in M with a corresponding increase in the interest rate (denoted by r) so that V decreases. Therefore V is a function of the interest rate, or V(r).

Assuming that we have a "super Central Bank" that is always able to set its policy interest rate at a level where monetary policy always offset the inflationary effect of fiscal policy, we have in period 0:

2) M₀*V(r₀) = P’*Q’

Since the economy is operating at capacity, the government should normally aim at balancing its budget in period 1. Instead, let's say that the government decides to run a one-time deficit in period 1, which adds to the net financial assets of the non-government sector. The Central Bank would then increase the interest rate in period 1 to decrease V in order to make sure that the government deficit is non-inflationary. We would then have:

3) (M₀ + ΔM₁)*V(r₀ + Δr₁) = P’*Q’

Where ΔM₁ is the government deficit in period 1, and Δr₁ is the increase in the interest rate in period 1 necessary to decrease V and keep inflation in check.

In period 2, assuming that the government withdraws its economic stimulus and goes back to a balance budget, then M would still rise as a result of the increase in interest that took place in period 1 (note: assuming that government debt in circulation is all short-term, then r is also the interest rate on government debt, therefore it is the interest rate at which net financial assets of the non-government sector compound). To make sure that this increase in M is non-inflationary, the Central Bank would need to raise the interest rate further by Δr_2. (I'm assuming here that the Central Bank adjusts r even it means an increase of a fraction of a basis point). We would then have:

4) M₂*V(r₀ + Δr₁ + Δr₂) = P’*Q’

Where M₂ = (M₀ + ΔM₁)*(1 + Δr₁)

A similar logic would prevail in period 3:

5) M₃*V(r₀+ Δr₁+ Δr₂+Δr₃) = P’*Q’

Where M₃ = (M₀ + ΔM₁)*(1 + Δr₁+ Δr₂ )

Again, a similar logic would prevail in period 4:

6) M₄*V(r₀ + Δr₁ + Δr₂ + Δr₃ + Δr₄) = P’*Q’

Where M₄ = (M₀ + ΔM₁)*(1 + Δr₁+ Δr₂ + Δr₃ )

And so on.

One can see clearly from the demonstration above that the Central Bank’s action is both the solution and the source of the problem: its increase in the interest rate in period 1 expands the net financial assets of the non-government sector (M) in period 2, which renders necessary a further increase in the interest rate to decrease V in period 2 in order to keep inflation in check, and this further increase in interest rate further expands M in period 3, which commands still a further increase in the interest rate to decrease V in period 3...and so on, and so forth.

The only definitive solution to this vicious cycle would be to use fiscal policy rather than monetary policy to eliminate the inflation threat originally caused by the government deficit in period 1. This would mean generating a budget surplus in period 2 that would exactly offset the budget deficit of period 1 plus the interest payment. The size of the budget surplus relative to GDP necessary in period 2 could be expressed as follow:

(M₀* Δr₁) + ((ΔM₁)*(1 + Δr₁)) / (P’*Q’)

Flowing from this analysis is the following critical policy implication: the longer the country tries to fight inflation with monetary policy, the bigger the size of the budget surplus relative to GDP that is necessary in the future to eliminate the inflation threat. For example, in period 4, the size of the budget surplus relative to GDP necessary would be:

 

(((M₀* (Δr₁ + Δr₂ + Δr₃ )) + (ΔM₁ *(1 + Δr₁ + Δr₂ + Δr₃))) / (P’*Q’)

This demonstration above explains why MMT holds that monetary policy is really an ambivalent tool when it comes to fighting inflation as increasing the interest rate could be both expansionary and contractionary with regards to aggregate demand. This observation holds even if one assumes that a "super all-knowing central bank" exists that is always able to adjust the interest rate perfectly in order to keep inflation in check. (i.e., the Central Bank is able to perfectly control the desired leverage of the non-governmental sector through monetary policy). (Note: most MMTers would argue that a central bank is incapable of doing such a thing to begin with)

Does this demonstration have any implications in the real world? In the Canadian context, I would say yes. To the extent that one deems the budget surpluses of the 1990s in Canada necessary, the high interest rates of the early 1990s likely made these “required” budget surpluses even larger.

Furthermore, one could speculate that a quid pro quo took place in the mid-1990s between the government and the Central Bank whereby the Central Bank accepted to slowly reduce interest rates if the federal government started tackling its deficit.