New Developments in the theory of inflation

1. New Developments in the theory of inflation Jacques SAPIR, PhD. Professor of Economics, EHESS-Paris Director CEMI-EHESS -Paris Sapir@msh-paris.fr

2. Lecture 1. The classical Theory of Inflation. • The historical debate. • The monetarist counter-revolution and beyond. • Lecture 2. Microeconomic Foundations of the « standard » theory and critics. • Standard microeconomics. • Standard microeconomics contested. • Lecture 3. The classical Theory contested. • Facts and figures. • Theoretical critics. • Lecture 4. Toward a new synthesis. • Theoretical crisis and paradigm shifts. • Model of inflation with sticky information and a new Synthesis. • Lecture 5. A new model of inflation and its policy implications. • Aims for a new model of dual-inflation • Policy implications.

3. Short bibliography • 1. From the lecturer. • In Russian • J. Sapir K Ekonomicheskoj teorii neodnorodnyh sistem - opyt issledovanija decentralizovannoj ekonomiki, Moscow, 2001, (p. 122-139). • J. Sapir, “ Stabilizacija i perehodnyj period: francuzkaja tochka zrenija na hod i rezul’taty reform v Rossii”, in V. Ivanter et J. Sapir (edits.), Denezhnye i Finansovye Problemy Perehodnogo Perioda v Rossii: Rossijsko-Francuzkij Dialog, Nauka, Moscou, juin 1995, pp. 266-301. • J.Sapir, "Novye podhody teorii individual'nyh predpotchenij i ee sledstvija" in Ekonomitcheskij Zhurnal, Vol. 9, n 3/2005, pp. 325-360. • J. Sapir, "Kakim dolzhen byt' uroven' infljacii? (O znatchenii davnykh diskuccij dlja opredelenija segodnjachej strategii razvitija Rossii)" in Problemy Prognozirovanija, n3/2006, pp. 11-22. • Other languages • J. Sapir, "Russia's Crash of August 1998: Diagnosis and Prescriptions", in Post-Soviet Affairs, vol. 15, n1/1999, January-March, pp. 1-36.

4. 2. Other Authors. • J.M.Keynes, "A tract on Monetary reform" (1926), in J.M.Keynes, Essays in Persuasion, Rupert Hart-Davis, London, 1931. • D. Patinkin, “Walras’Law” in J. Eatwell, M. Milgate et P. Newman (Edits.), General Equilibrium - The New Palgrave, Macmillan, Londres, 1987. • J. Tobin et K. Buiter, "Long-run effects of fiscal and monetary policy on aggregate demand", in J. Stein (ed.) Monetarism, North Holland, Amsterdam, 1976, pp. 273-319. • F. Hahn, "Monetarism and Economic Theory", in Economica, vol. 47, n1/1980, pp. 1-17. • B.S. Bernanke et F.S. Mishkin, "Inflation Targeting: A New framework for Monetary Policy" in Journal of Economic Perspectives, vol. 11, n1/1997, pp. 97-116. • G.A. Akerlof, W.T. Dickens et G.L. Perry, "The Macroeconomics of Low Inflation" in Brookings Papers on Economic Activity, n 1/1996, pp. 1-59. • T.M. Andersen, "Can Inflation Be Too Low ?" in Kyklos, vol. 54/2001, Fasc.4, pp. 591-602. • B.C. Greenwald et J.E. Stiglitz, "Toward a Theory of Rigidities" in American Economic Review, vol. 79, n2, 1989, Papers and Proceedings, pp. 364-369. • J. Furher et G. Moore, "Inflation Persistence" in Quarterly Journal of Economics, vol 110, n1/1995, pp. 127-160. • G.N. Mankyw et R. Reis, "Sticky Information versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve" in Quarterly Journal of Economics, vol. 117, n4/2002, pp. 1295-1328

5. LECTURE 1The classical Theory of InflationPart-1: The historical debate • Say ’s equality and uncertainty. • Say’s microeconomics. • Say versus Cantillon. • Revisiting Cantillon • How Walras « liquidated » money and inflation. • Walras’ Law and monetary equilibrium. • Walrasian equilibrium and Barter Trade • Inflation as ‘ class struggle ’ (not who you would think at first…actually Max Weber and J.M. Keynes). • Weber’s theory of monetary prices. • Keynes and the social dimension of inflation and deflation (1924).

6. Inflation as a microeconomic process: von Hayek (1932). • The ‘ demand for money ’ theory: from Wicksell to Keynes ’ Treatise on Money (1930). • Wicksell and the two rates of interest theory (monetary equilibrium IS NOT general equilibrium). • Keynes’ theory of the demand for money. • Trading • Insurance • Speculation • Keynes and the “Liquidity Trap”. • Gunnar Myrdal and the “ex-ante” vs “ex-post” interest rate. • Georges Shackle and the post-Keynesian synthesis: liquidity is related to uncertainty. • The Unexpected and the Counter-expected. • Keynes and Cantillon: a new view on the liquidity trap.

7. Part-2The ‘ monetarist counter-revolution ’ and beyond • Rational expectations and ‘ demand for money ’. • Why would “rational agents” keep their assets liquid ? • The Bomol-Tobin interpretation of the demand for money function. • The Friedman synthesis: permanent income and money neutrality. • What is the “permanent income”. • The long-term neutrality assumption and Friedman’s arguments against the Phillips Curve. • Money creation as an exogeneous process.

8. The price to unemployment relation controversy P Friedman Interpretation Of the price to unemployment relation Traditional Phillips curve UnR NAIRU

9. Robert Lucas theory of money: the birth of the « new-classical school ». • Methodological rejection of uncertainty. • Perfect substitution of wealth assets. • Rational expectations and government policy. • Microeconomic foundations and macroeconomic implications. • No “monetary illusion” • Inflation is a pure monetary phenomenon. • Iliquidity is Insolvency. • The ‘ standard ’ theory of inflation by early 90 ’s. • Money does not create wealth so restrictive monetary policies can’t destroy wealth. • Assets mobility prevents local rents under restrictive monetary policies. • “0” inflation is the best target.

10. Lecture 2Microeconomic Foundations of the « standard » theory and critics.Part-1: Standard microeconomics • The “rational individual agent” : main axioms • (a) Individual preferences: • Complete pre-ordering of preferences implying transitivity and reflexivity. • Preferences are continuous (no discrete choice). • Non-saturation of individual preferences. • (b) The Subjective Expected Utility Assumption. • Preferences are to be independent (if x>y>z, then any mix (x,z) generates an utility greater than any mix (y,z)). • Temporal monotony and Temporal integration. • (c) Rationality is maximising the SEU

11. Rational choice as a global explanation. • Gary Becker and the society as a sum of “rational choices” • The Permanent Income theory as SEU maximization. • U inc = f (m, B, St, Fcap, Hcap), where m is total monetary assets, B total wealth in bonds, St total wealth in stocks, Fcap total wealth in fixed capital and Hcap wealth in human capital. • All capital assets are generating an income flow which is (a) computable and (b) probabilistic. • The “Hard Budget Constraint” Theory. • A basic assumption (the “budget constraint”). • Kornaï and an institutionnalist approach of microeconomic behaviours. • Institutions generate the budget constraint. • Agents adapt to the budget constraint? • Implications for macroeconomic dynamics and inflation. • Implies that Liquidity = Solvency (which is true under perfect information…)

12. Part-2: Standard microeconomics contested • The Allais paradox (Maurice Allais, 1953). • Why preferences instability? • The “common consequence” problem. • Rational choice under uncertainty: Herbert Simon. • Cognitive saturation. • Routines vs Innovation. • Procedural vs Substantive rationality, and Keynes’ preference for liquidity. • Reversal of preferences (Slovic, Lichtenstein). • The Allais’ Paradox revisited. • Problems in gambling. • Non-transitivity in preferences.

13. The new context-dependent theory of individual preferences (Tversky and Kahneman). • The “Endowment Effect” • The “Framing Effect” • Preferences as a constructive, context-dependant process (Tversky & Thaler: A. Tversky et R. Thaler, "Preference Reversals", Journal of Economic Perspectives, vol. 4/1990, p. 201-211) • Back to Keynes and Max Weber? • What rationality is? • Contextual rationality. • Substantive rationality as a specific case. • Switch between models of rationality. • Limits of axiomatic reasoning.

14. Lecture 3The classical Theory contestedPart-1: facts and figures. • The classical theory meets its match. • Russia vs China. • Indonesia vs Malaysia. • Japan’s deflation in the 90’s. • EU inflation diversity. • Traditional stabilisation success stories revisited. • How Israel was stabilised in the 80’s. • How Jeffrey Sachs did not stabilise Bolivia. • Are lessons of hyperinflation stabilisation relevant for stabilising “simple” inflations.

15. The “core inflation” phenomenon. • What is “core inflation”? • How much for a “core”: US and European experiences. • Why “core inflations” are not the same? • Could “core inflation” be significant: France and Italy in the 50’s and the 60’s.

16. Growth compared (GDP index 100 = 1960)

17. Part-2: Theoretical critics. • G. Akerlof and the “too low inflation” paradigm. • Wages rigidity. • Rigidity and Uncertainty • Rigidity and Competition: strategic behaviour. • The “nominal debt” effect and the return of the monetary illusion. • A model of the US economy, 1925-1990. • The price rigidities explanation. • Monetary prices and relative prices. Why a changing economy “needs” inflation: the “Hayekian Inflation” paradigm. • Prices indexation and the technical chain paradigm: a model of technically induced inflation propagation. • Prices and industrial branches specificity: differences in decision temporality and pricing behaviour.

18. The “output gap” notion. • What the “output gap” is. • Non-neutrality of money. • Measuring the output gap. • Microeconomic explanations. • Constructive preferences (Framing and Endowment effects). • Asymetric information and the “nothing to loose” behaviour. • Cognitive saturation (and procedural rationality).

19. Lecture 4.Toward a new synthesis.Part-1: Theoretical crisis and Paradigm shift • Theoretical crisis from the mid-90’s on. • Traditional “monetarist” models have logical inconsistencies, detected as early as 1971 by Frank Hahn. • “New-Classical” models (R. Lucas) imply no uncertainty and Lucas himself has been disenchanted with them. • Models with random price adjustment (Calvo and Taylor) also called models with “neo-Keynesian Phillips curve” are generating counter-factual results. • New-Keynesian models (models with nominal rigidities as the Akerlof-Dickens-Perry) are proving much better to simulate actual economic movements. • “Standard” macroeconomics unable to explain actual life dynamics and unable to cope with advance in microeconomics.

20. Paradigm shifts: • Stabilisation policies can be harmful. • Deflation is worse a threat than inflation in some case (Japan). • Inflation is to be “targeted” more than fought to the finish. • Growth is as important than price stability (relevance of the output gap). • Economics need a more realistic description of the individual agent, including cognitive limitations. • Money is NOT neutral.

21. Main assumptions: Price adjustments are not optimal through lack of time to process information. Strong follow-the-leader process among enterprises in the same sector. Strong strategic complementarity among different sectors (variables in log) p(t) = f (p(t-n)) Spontaneous indexation effect p(xi) = f (p (xL) ) Monopolistic pricing even in a competitive market. p (xA) = f (p (xB) ) Cross-sectoral indexation. Part-2: Model of inflation with Sticky Information and the new synthesis

22. Microeconomic price setting function: p*k = p + ak x + E k p = ∑ (t ki * p ki ) With: p*k = standard price growth in sector k p = CPI ak = sector k sensibility to the global business cycle. x = output gap EK = endogeneous shocks in sector k Results: Strong inertial component, not linked to market imperfections in inflation dynamics (up to 7 quarters). Strong negative effect of stabilisation policies on output. Adjustment to the output gap at the enterprise level could generate effects leading to more inflationary pressures. There is a minimum threshold for inflation in each economy, and it is > 0. Gregory Mankew and Ricardo Reis models: Keynesian dynamics from former monetarist authors...

23. Is a new Synthesis in the coming? • Sticky Information models demonstrate that “typical” Keynesian results can be generated from the new-classical framework IF more realistic assumptions are made. • Sticky Information models (Mankew and Reis) and new-Keynesian ones (Akerlof-Dickens-Perry) are converging on the same set of results and prescriptions. • Advance in microeconomics (cognitive saturation, information asymmetry, constructive and context-dependent preferences) are destroying most of the Monetarist counter-revolution foundations. • Consistency between microeconomics and macroeconomics IS needed and IS possible. • But would this synthesis be enough?

24. And now, coming next and soon... • Lecture 6: A two sectors model of dual inflation. • Presentation of the model. • Resolution and variants. • Lecture 7: Estimating the structural inflation dimension. • Western Europe 1950-1980. • Russia 2000-2008. • Lecture 8: Is there a financial dimension in inflation. • The financial system as a constraint. • Financial bubbles and Asset Prices inflation. • Lecture 9: Dual inflation in an open economy. • Competitiveness and the change rate issue. • Regional currency agreements under fire (the Euro). • Lecture 10: Toward new macroeconomic policies. • What stabilisation is (short-term vs. long-term). • Developing effective financial systems.