Mainstream Monetary Economics: A Package of Logical Fallacies

The mainstream monetary economics is filled with contradictions, logical inconsistencies, missed and messed normative implications and data inconsistencies. There exist heterodox theories having better match with historical data, but the theories are often undermined and ignored. It is in fact difficult to find something logical and valid in classical monetary economics. Despite a clear empirical failure, monetary economics is still widely believed which is quite surprising.

Thomas Tooke is perhaps the first person to produce a book in monetary economics. In 1857, he wrote a book titled ‘History of Prices and of the State of the Circulation during the Years 1793–1856’. He is also a pioneer of the ‘Banking School theory’. This theory predicts that higher interest rates should be associated with higher price levels. The logic for this view is very simple; the interest rate is a part of cost of production for the firms. Higher the interest rate, higher would be the cost of production leading to higher prices. This is the oldest theory on the relationship between interest rate and inflation.

However, mainstream economics adapted an opposite theory known as demand channel of monetary transmission. This says that if the interest rate increases, the people will reduce spending and there would be a reduction in aggregate demand which will lead to reduction in prices. This view was adapted at least as early as the 1890s and is popular to date. The inflation targeting framework which is the most popular framework for designing monetary policy today is also based on this hypothesis.

Historical data in every time period provided evidence against the demand channel. The most popular of the early evidences against the demand channel is findings of Gibson. Gibson (1923) analyzed the data on interest rate and prices for the United Kingdom for about 200 years and found that the high interest rate is associated with higher prices; something which is matching with Tooke’s view and supported by the oldest theory in monetary economics.

The findings of Gibson were so impressive that Keynes recognized his findings as ‘one of the most completely established empirical facts in the whole field of quantitative economics.’. However, Keynes termed this finding as ‘Gibson paradox’ indicating absence of any theory to explain the observation. Given the presence of Tooke’s Banking School Theory, this labeling was erroneous. However, Keynes’ recognition was a strong support to the idea that interest rate and inflation are positively associated. This is quite opposite to the logical foundations of the inflation targeting framework.

The history goes on and the empirical evidence supporting Tooke’s view were ignored by labeling as paradox. In the 1970s, there was a re-invention of supply side economics and people discussed the possibility of a cost channel of monetary transmission mechanism. This was strong theoretical support to the positive association between interest rate and inflation.

In 1992, Sims produced his seminal paper where he found that impulse response of inflation to changes in interest rate is positive. Despite the stature of Sims who later won the prestigious Nobel Prize, his findings were labeled as ‘price puzzle’, to indicate absence of theoretical underpinning of the observation. This was a denial of Tooke’s theory and the cost channel.

Brazil reduced policy rate from 14% to 2% during the three years starting from 2017. Such a drastic cut in interest should skyrocket the inflation if the widely believed demand channel was valid, but the opposite happened. The inflation in Brazil during 2017 has been about 10% which is now below 6%.

Graph showing trend in interest rate and inflation in brazil for 2015-2021. from 2016 to 2020, interest rate dropped from 14% to 2%, and the inflation also reduced.

The response to the Global Financial Crisis and Covid-19 also mark the failure of classical monetary theory. All major economies responded to the pandemic by reducing interest rate and the inflation also reduced. Despite this failure of monetary theory, the international financial institutions such as IMF use to advocate the inflation targeting, which is quite strange.

The graph shows trend in interest rate and inflation in UK. in 2020, the interest rate was suddenly reduced from 0.7% to 0.1%. The mainstream wisdom predicts a rise of inflation after reductionin interest rate, but inflation also reduced after the fall in interest rate.

Besides the contradictions with empirical evidence, there are logical inconsistencies and messed and missed normative implications. Assume for a while that the demand channel is valid i.e. increasing interest rate reduces inflation. If so, it can happen only through the luxuries. The demand for necessities cannot be reduced significantly. Therefore, if any reduction in aggregate price level occurs, it must be driven by prices of luxuries. Therefore, the rise in interest rate will improve the purchasing power of consumers of luxuries, and would be ineffective to improve the prices of necessities. There are very obvious normative implications, but conventional monetary economics never discusses the normative implications of monetary policy. That’s the missed normative implication.

Assume for a while that the traditional demand channel exists and that increase in interest rate reduces the prices. The demand channel also implies that a higher interest rate leads to increase in unemployment. Therefore, the cost of price stability shall be borne by those who will lose their jobs. It is also well known that those who are at the risk of losing jobs are the poorest people. Therefore price stability comes at the cost of the most vulnerable cohort of society, another very serious normative implication. But the traditional monetary economics totally ignores the normative implication of monetary policies.

It is also clear that any real implication of inflation on the economy comes from relative price movement. If prices of all goods and services increase at the same rate, no real variable would be affected; an implication known as monetary neutrality. Contrary to monetary neutrality, the Phillips curve assumes that inflation affects employment, and so happens due to differential in the price changes for wages and commodity prices. This means, focusing aggregate inflation is meaningless. One needs to look at the relative movement of sub-indices of the consumer price index. But the monetary policy especially the inflation targeting framework explicitly focuses on aggregate price level without taking any care of the relative price movement. There is no explanation for this in the literature.  

In short, if you try to look into theoretical underpinning of monetary policy, you will find them to be very weak. If you look at the empirical data, the data shows invalidity of the underlying hypothesis. If you look into normative implication, you will find many which are practically ignored. Therefore, the textbooks on monetary economics need a rewrite, and an alternative monetary theory need to be developed which should be based on empirical data, not on the basis of hypothetical theories. 

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Author: Atiq Rehman

Dr. Atiq –ur-Rehman is Associate Professor and Director at Kashmir Institute of Economics, University of Azad Jammu and Kashmir. Before joining University of Azad Jammu and Kashmir, he has been an Assistant Professor of Econometrics at Pakistan Institute of Development Economics, Islamabad, Pakistan’s leading university in economics and at International Islamic University, Islamabad on similar position. He holds PhD in Econometrics from International Islamic University, where he wrote his thesis under supervision of Dr. Asad Zaman. Dr. Atiq teaches Econometrics and Statistics especially theoretical and time series econometrics and statistical research methods. He also has interest in teaching Monetary Economics Dr. Atiq has formal training in Econometrics and has vast experience of utilizing his econometric skills in various economic related disciplines. His published research relates to Development Studies, Islamic Banking Finance, Monetary Economics and Econometrics. He has supervised large number of students in their MS/PhD theses and has presented his research in several international events. Dr. Atiq also has deep interest in Islamic economics and Islamic finance and has presented his research in on Islamic finance in several international conferences.

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