...against fictions and other tall tales

Friday 10 February 2012

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 Δr2. (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.


  1. Very good post!

    Scott Fullwiler

    1. nod for your nod! SF. but you spend too much of your valuable time explaining to zealots. get into politics; that's where you're needed mostly.

  2. nod!! clear and concise. will generate a discussion on some of your observations re the 'extent' of the role of monetary policy, esp in the canadian context.
    mmt-ers should read this-will save some useless chatter and much time and space.

  3. JL, this is a solid piece and I'm glad you posted it here. In fact, the issue of using fiscal policy as inflation control has been an interest of mine for a while. As you probably know, I enjoy going back to the older texts such as Keynes, Boulding and Tarshis for inspiration (i.e., tried and tested policy advice). These economists understood that taxation had a huge role to play in fighting off inflation. As one of my favorite Keynesian once put it (Tarshis): "When increased taxation is imposed, the heavy hand of the tax collector keeps the store from being overcrowded...".

    Also, I think this fits in nicely with another aspect of MMT: the manner in which tax "drives" money (i.e., how taxation works to maintain the value of money). As MMT suggests, without taxation, the demand for money would plummet to zero, eroding its value entirely. That some people still doubt the role of taxation in providing a floor to the value of money surprises me. But setting that aside for a moment, as I always say in my posts, my focus is mostly on the policy implications of all this. So here's my question: Do you think there is a way to connect MMT's stance on inflation control via fiscal policy with the idea advanced by some mainstream economists (e.g. Bruce Smith of the FRS) that money is/should be backed by a commitment by government to increase future income streams (to retire money at a future date or/and achieve a surplus)? See "Money in inflation in colonial Massachusetts", Federal Reserve Bank of Minneapolis Quarterly Review, Winter.


    I'm asking because I believe MMT would benefit from developing a strategy toward policy that is much longer-term in regard to aggregate demand management and inflation control. Your post makes it very clear that there *is* a longer-term in MMT: it's not all about deficit spending. In other words, I'm wondering if there isn't a way of explaining the benefits of functional finance by always adding a word or two about the longer-term requirements of a stable economy (including the possibility of having to implement contractionary fiscal measures in the long-run to address inflation).

    The reason I'm asking is that I tend to agree with many mainstream economists that it's not enough to simply call for additional fiscal stimulus without also explaining the appropriate measures to address the pressures that may ensue from a stretch of budgetary deficits. I know it's not always feasible to explain economic policy in this way (I'm guilty of it too), but I believe that MMT should make a point to always supplement its call for additional stimulus with follow-up statements on ways to address any longer-term potential problems such as inflation or supply shortages, etc. Stated differently, I think MMTers are right to be dovish (owlish?) in the immediate term. But they should also aim to be hawkish for the longer term. People would really gain from understanding the stuff you write about in this post. Most people think MMT is all about deficits. It would be great to hear an MMTer respond to Bernanke's call for a plan that would enable the US economy to return to a more sustainable path (see his speech, Feb 2, 2012) by explaining how deficits now will require corrective action (either via monetary or fiscal policy) later on. Any thoughts?

    Also, I think it's absolutely essential for MMT to include as a precursor Milton Friedman's 1948 "Fiscal and Monetary framework for Economic Stability". This would help remind everyone that fiscal action does have a role in controlling inflation. I mean, you've done most of it here. It just needs to be known by all that Friedman once supported these ideas too. Also, it might attract some smart monetarists (and there are many out there) to join the discourse (nod to Jorge).


  4. Joseph Laliberté28 February 2012 at 21:35

    Thanks circuit,
    Lots of good food for thought here. I will have to think more about some of the points you are raising. A word of caution though with respect to being hawkish in the longer term. I often found that being hawkish in the long term (à la Krugman) is self-defeating, since most people then immediately jump to the conclusion that since we have a problem in the long term, we better deal with it now than leaving it to our grandchildren! It is impossible to predict if and when accumulated deficits will lead to inflation as it depends to a large extent on the future desired leverage of the private economy. For example, I have no idea as to when Japanse's non governental sector desire to leverage will start to grow again, this is a known unkown. i think that MMT would emphasise the importance of improved automatic stabiliser (e.g. buffer stock of employment) to deal with inflation -in effect trying as much as possible to put fiscal policy on automatic pilot so that it could become contractionary without active political intervention.

    Thanks for the Friedman reference, I remember reading the "young" Friedman (circa 1948) and wondering if it was the same Friedman that all economists talk about!

  5. Joseph says “its increase in the interest rate in period 1 expands the net financial assets of the non government sector (M) in period 2”. The effect is to CONTRACT net financial assets isn’t it?
    To increase rates, the central bank sells government debt, which REDUCES its value or price, which in turn raises rates. Or have I missed something?

  6. This was an interesting post.

    What you describe is quite reminiscent of a mainstream approach called the Fiscal Theory of the Price Level, where the government's intertemporal budget constraint is taken to be an equilibrium condition rather than an accounting identity, and then used to pin down the equilibrium price level.

    Anyway, some random observations / questions whilst I try to get my head round it.

    In your model, the CB cannot increase or decrease M, except indirectly via the path of the interest rate.

    When the CB raises the interest rate, M will increase, which is inflationary, other things equal.

    Do I have that right?

    If so, doesn't that depend on how the government finances those interest payments? I.e., the government doesn't have to issue bonds, as far as I can see, but could raise taxes instead.

    (Incidentally, mainstream types also believe that interest rates can have contradictory effects--google "price puzzle").

    What's going on with V? Can someone explain or point me at a link that explains what it means? (The link to Scott Fullwiler's quote is dead, BTW). It's obviously not velocity. The standard interpretation is the nominal money stock times the rate at which it changes hands is equal to nominal income. Are you saying that NFA times the leverage ratio of NFA to "money like assets" or broad money or whatever equals nominal income?

    1. Vimothy, I re-directed the link. It should work now.

    2. Circuit,

      Thanks. Just noticed the date on this post. Please ignore my ramblings, which were mostly just me thinking aloud.

  7. Andrea Terzi has also written on this:


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  11. We need an analogy that makes the aim of MMT clear and complete. Focusing on the idea that money is a flow and a stock, let’s adapt a basic equation from hydrology that concerns function of the inflow I and the out flow O show changes in the quantity of water in a swimming pool. Let S be the amount of water stored in the pool. Then the change in storage of water in the pool is given by the simple equation
    I - O = ΔS
    If I > O then ΔS is positive. Water is added to the storage in the poo . If I < O, then ΔS is negative. Water is draining from the pool.

    Let S' be the quantity of water in the pool when the pool is full. The aim is to introduce new water into the pool as I, while water is leaving at a certain rate, O. To fill the pool I should be greaer than O until storage equals S'. After water in the pool reaches S’, the input I should be adjusted to just equal the outflow O. At that point
    ΔS is zero. We will continue to fill the pool as long as it is not overflowing beyond the pool's capacity. If there are several sources of water inflowing into the pool and several drains through which water is draining out of the pool, we can consider moderating flows by adjusting the different inflows and outflows. And we must consider the whole
    inflow and outflow.
    Now let C be the amount of money in circulation. Let inflows to C fall into three categories : E (exports), G (government spending), I (investments from savings). Similarly outflows are: M (imports), T (taxes), S (savings). Then
    (E+G+I) - (M+T+S) = ΔC
    where ΔC denotes the change in quantity of money in circulation. Let C' denote the amount of money in circulation at full production and full employment at stable prices and wages. We do not want to fill circulation to where it is
    overflowing. That corresponds to not wanting inflation.
    However, if there is deflation, we need to restore C to C’. The fungibility of money means that we can exchange dollars in one flow category for dollars in another category.

  12. We also need to relate this analogy with a swimming pool to how we would fight inflation. Inflation occurs when there is an excess of money in circulation beyond what is needed to clear the market of goods and services at stable prices at full production and employment. Excess money needs to be removed from circulation. Besides raising taxes and cutting spending to get a surplus (which drains from circulation), government can encourage imports, and even sell Treasury securities to absorb excess money into time-deposit accounts at the Fed. Government can encourage saving by raising interest rates.
    In deflations (recessions and depressions) government (Fed) can buy T securities from banks to increase bank reserves; govt can lower interest rates to encourage lending (which creates new money into circulation until returned in payment of the loan). It can encourage education, manufacturing, to create exports. It can deficit spend to create money immediately spent into the economy. There is no inherent move to hyperinflation. Hyperinflations come when a nation owes money in foreign currency and is caught up in trying to beat the devaluation of its currency at the foreign exchanges by creating new money and buying the foreign currency with it. By keeping one's eye on indicators of inflation government can seek to control it with the means described. Congress has to be a part of this process.

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