–Preventing and Curing Inflation: Modern Monetary Theory vs. Monetary Sovereignty

As I frequently make clear, Monetary Sovereignty is a first “kissin'” cousin to Modern Monetary Theory. They agree on virtually everything, with the exception of the prevention and cure for unemployment and the prevention and cure for inflation.

I touch on both of these at: https://rodgermmitchell.wordpress.com/2012/01/01/why-modern-monetary-theorys-employer-of-last-resort-is-a-bad-idea/ and at https://rodgermmitchell.wordpress.com/2012/01/02/a-reminder-about-why-modern-monetary-theory-mmt-is-wrong-about-inflation/

Warren Mosler and I have had several discussions about inflation and its prevention and cure, with him taking the position that money supply is the key, and me taking the position that money value is the key. For a more complete discussion,, You might look at the inflation post listed above and at https://rodgermmitchell.wordpress.com/2011/04/18/how-monetary-sovereignty-differs-from-modern-monetary-theory-simplified/

In summary, Warren believes raising interest rates is inflationary, because it increases costs (true), and I believe the cost increase is relatively small, and raising interest rates is deflationary, because it increases the value of money.

Today, Warren sent me an Email containing a slightly esoteric, 26 page paper titled, Is There a Cost Channel of Monetary Policy Transmission? An Investigation into the Pricing Behavior of 2,000 Firms

Author(s): Eugenio Gaiotti and Alessandro Secchi Reviewed work(s):Source: Journal of Money, Credit and Banking, Vol. 38, No. 8 (Dec., 2006), pp. 2013-2037
Published by: Ohio State University PressStable URL: http://www.jstor.org/

Warren had received the paper from Nathan Tankus, who said: “Attached is a paper showing empirical support for the cost channel view of monetary policy. What’s significant is that it appears in a very main stream journal (Journal of Money, Credit and Banking). Thought you’d like to have a copy of this.
Nathan Tankus”

Warren sent the paper to me, with this comment: “Part of what I’ve been suggesting- rate hikes may cause inflation etc.

My response:

“What they (Gaiotti and Secchi) said is: ” . . . in the short run an increase in interest rates may cause prices to rise, rather than to Fall. However, empirical evidence in favor of this hypothesis is not abundant and remains controversial. Virtually all of it is based on aggregate-sometimes sectoral-data and, in particular, on the identification of a short-term positive response of aggregate prices to interest rate shocks. It is well known that macro-evidence regarding the effects of monetary shocks is subject to substantial identification and specification problems and, consequently, to considerable uncertainty of interpretation.

Lots of “short run” (one day??), “evidence . . . not abundant,” “controversial” and “uncertainty” words in that paragraph.

I understand the notion that higher interest rates add to business costs, though for most businesses, an increase in interest rates would amount to a minuscule addition to overall costs.

However, the most powerful, empirical evidence we have is this: For many years, the Fed successfully has raised interest rates to control inflation. If raising rates actually caused inflation, and the Fed was compounding the inflation problem, surely that effect be obvious by now.


Taking the MMT side, unquestionably an interest increase can increase business costs. Even more so when you consider that some businesses sell to other businesses, and if everyone is borrowing, there will be a multiplier effect. Further, increasing interest rates forces the federal government to pay more on its debts, which adds to the money supply. All of this can be inflationary.

On the Monetary Sovereignty side, increasing interest rates increases the value of the dollar vs other currencies and non-money. This makes imports less costly, and because imports continue to be of increasing importance to our economy, their anti-inflationary effect grows. Even for products that are manufactured in the U.S., imports of parts and raw materials are sensitive to the strength of the dollar.

Since all sales really are a form of barter, in which dollars are traded for goods and services, the more valuable the dollar, the fewer will be needed to trade.

As an aside, the Gaiotti and Secchi paper specified “short run,” and one might question whether this is of prime importance, even if it occurs.

Given all of the above hypotheses, I lean toward the empirical evidence that what the Fed has been doing –raising rates to stop inflation — seems to have kept inflation near the Fed’s target. This approach also has the advantage of being fast, effective in tiny increments, and apolitical.

Contrast that with changing the money supply via tax increases and spending decreases (the MMT) approach, which is slow, requires large, uncertain increments, and is highly political, affecting specific groups unfairly.

Rodger Malcolm Mitchell

No nation can tax itself into prosperity, nor grow without money growth. Monetary Sovereignty: Cutting federal deficits to grow the economy is like applying leeches to cure anemia. Two key equations in economics:
Federal Deficits – Net Imports = Net Private Savings
Gross Domestic Product = Federal Spending + Private Investment and Consumption + Net exports


24 thoughts on “–Preventing and Curing Inflation: Modern Monetary Theory vs. Monetary Sovereignty

  1. Wow. I’m pleasantly surprised that sending a link sparked a blog post. Before i respond I’d like to point out that I’m unsure of the the complete affect on inflation of interest rate changes but i do think it is much more complex then is generally recognized.

    First i want to point out that the paper I sent is an empirical paper published 5 years ago that is explicitly designed to combat the problems with earlier studies described. it is worth quoting the conclusion:

    “We draw three implications from our study. Methodologically, using a unique dataset, we conclude that individual data on firms’ pricing behavior give robust and direct evidence of the fact that monetary policy also works through the supply side; unlike previous results, we consider this evidence to be largely immune to the identification problem which plagues the time-series literature…From a normative point of view, the effect is economically significant;the adverse impact of interest rate hikes on the price level during a typical restriction cycle may not be negligible; the magnitude of the supply-side effect is such that it affects the optimal course of policy of a credible (i.e., able to commit) central bank, possibly calling for more gradualism.”

    Second this is hardly the only empirical paper (although it is quite a good one which is why i forwarded it) and a lot has been written on this subject in the New Keynesian literature. it even has a snazzy title: “the price puzzle”. Using google Scholar, We discover that 185 papers have “cost channel” in the title in the “Business, Administration, Finance, and Economics.” section. for the same search you get 147 results for “price puzzle”. This is hardly a small body of literature. That does not mean that you’re wrong and Warren is right (I’m sure there are papers both “proving” and “disproving” the cost channel that we would reject because of flawed new keynesian methodology), it simply means that there is a large literature out there that is relevant to this issue.



    “On the Monetary Sovereignty side, increasing interest rates increases the value of the dollar vs other currencies and non-money. This makes imports less costly, and because imports continue to be of increasing importance to our economy, their anti-inflationary effect grows. Even for products that are manufactured in the U.S., imports of parts and raw materials are sensitive to the strength of the dollar.”

    I think this argument is not very strong. First interest rate changes effect asset prices with interest rate increases (decreases) causing capital losses (gains). an initial rise in interest rates is just as likely to cause a capital outflow and an exchange rate decline if investors take it as a signal that further interest rate increases (capital losses) are coming. in this context the Chartalist policy of reducing interest rates to zero and making ti clear they will keep them there can actually keep the currency at a higher value then otherwise because investors will be reassured that the fed won’t cause a string of capital losses at any moment. in fact, to truly get the effect you’re looking for i think that announcing an interest rate decline and the fact that you will lower interest rates once every sixth months for the foreseeable future would have the effect you’re looking for. it would also have the added benefit of working through the cost channel in reverse.


    1. Thank you, Nathan.

      Because so many variables are in play, we continually are faced with, “Yes, but . . . ” objections. My “back-to-square-one” question is: If raising interest rates causes inflation, and the Fed has been raising rates every time it sniffs inflation, why have we not had an uncontrolled inflation?

      If MMT were correct, the Fed’s policy of raising interest rates in the face of inflation, would add fuel to the fire, in a never-ending upward helix of inflation.

      Rodger Malcolm Mitchell


  2. “In summary, Warren believes raising interest rates is inflationary, because it increases costs (true), and I believe the cost increase is relatively small, and raising interest rates is deflationary, because it increases the value of money.”

    How does interest rates relate to the amount of Govt bonds.

    For example if a Govt

    -Increased interest rates but did not increase the amount of bonds
    Compared to
    -Increasing interest rates and issuing (a lot) more Govt bonds

    If there were more Govt bonds at the appropriate interest rates to find buyers then surely this would decrease the amount of money in circulation so would lower inflation. Business costs would increase but so what if more money is sitting in bonds. During a boom they would just have to accept less profit.

    Maybe my understanding is limited but I can not see why more Govt bonds (at whatever rate is required to find buyers) would not always reduce monetary inflation.


  3. And thanks for addressing this issue.

    I have argued on various sites that Gordon Brown could have stopped the UK boom (up to 2007) simple by issuing more Govt bonds at the appropriate interest rate. But others disagree and I do not know enough on this but logically it makes sense to me that bonds are a new asset for the same money to chase.


  4. On the Monetary Sovereignty side, increasing interest rates increases the value of the dollar vs other currencies and non-money.
    Is it so on the long term? On the short term, that seems to be true, but on the long rate, there must be more to it.
    I see interest rates somewhat stable, yet euro keeps falling against the other currencies. And for example, Hungary’s high rate of inflation while the Central Bank’s interest rate is also very high…
    I don’t know, probably this needs more research, on both sides of the question.


  5. RMM, “…changing the money supply via tax increases and spending decreases (the MMT) approach is slow, requires large, uncertain increments, and is highly political.”
    Wouldn’t you add, “and could cause a recession or depression depending upon the degree of change.”
    Perhaps Steve Keen got it right,i.e.,private debt acceleration as manifested in bubbles ???
    “Believe nothing merely because you have been told it…
    But whatsoever, after due examination and analysis,
    you find to be kind, conducive to the good, the benefit,
    the welfare of all beings — that doctrine believe and cling to,
    and take it as your guide.”
    — Buddha
    [Gautama Siddharta] (563 – 483 BC), Hindu Prince, founder of Buddhism


  6. Rodger, how about one of your graphs showing the Fed Funds rate vs. inflation over time?

    My impression is that the causal relationship for a FFR increase is that rising rates tend to reduce private sector borrowing and increase the marginal propensity to save out of income, both of which mathematically and directly translate to lower private sector spending and thus a recession, and the falling aggregate demand moderates the perpetual increase in CPI. (I.e., CPI continues upward, but at a slower rate. Only for very short periods, not more than a few months, and only during severe recessions, have we had falling prices — at least since we became monetarily sovereign.)

    That is, lower inflation is a second-order effect of higher interest rates. Still, that is why the Fed raises rates, to get that second-order effect, even at the cost of the first-order effect.

    If you want to impose “all things being equal”, so that you postulate that along with rising rates from the Fed, the Treasury increases spending or lowers taxes so as to EXACTLY offset the reaction of the private sector to the higher interest rate, then I think Warren is right, the net effect is simply an increase in private income, which would result in upward pressure on growth and prices.

    In practice, what motivates the Fed to raises rates is coincident with high GDP growth and shrinking deficits, and the shrinking deficit combines with the higher interest rates to doubly stifle private sector demand.

    It’s more problematical to examine reductions in interest rates, because they tend to occur mostly during and immediately after recessions, when demand is low and businesses have a tough time raising prices, and little interest in borrowing and investing, no matter how low the interest rate. In the absence of a balance sheet recession, though, the effect should be the opposite of rising rates during a boom. People might borrow more, or refinance their debt, and save less, both of which would tend to increase aggregate demand and raise production. The effect on prices would be very little at first, until some of the slack is taken out of capacity, and is only a second order effect of the interest rate cut, if that can be credited for the boom. As before, the recession also tends to increase deficits, and it is mainly the increasing deficits which cause the recession to end and the next boom to begin.

    If the Treasury were to maintain a constant deficit as the recession unfolded, instead of increasing it, then the only effect of the reduction in interest rates would be a reduction in private sector interest income, which would tend to lower prices,not raise them.


    1. The graph can be interpreted both for and against interest rate increases to prevent/cure inflation. It’s that “all-things-being-equal” problem. The primary cause of inflation is oil prices — much more influential than interest rates. See: https://rodgermmitchell.wordpress.com/2010/04/06/more-thoughts-on-inflation/


      I continue to feel that If MMT were correct, the Fed’s policy of raising interest rates in the face of inflation, would add fuel to the fire, in a never-ending upward helix of inflation.


      1. It seems that the graph clearly shows a rising blue line preceding each grey bar, and that the red line reverses from rising to falling during the grey bar.

        Raising the FFR causes recessions, and recessions cure inflation.


  7. Rodger, is there a more fleshed-out case you can point to, setting out what you think causes inflation (other than interest rates simply being too low – or rather, the USD being too high)?

    I know you have highlighted the oil price in the past and I do find this convincing. But DeLong has a detailed account of the 1960s/70s inflation here (http://econ161.berkeley.edu/econ_articles/theinflationofthes.html) and it suggests something else is definitely going on ahead of the first oil price shock.


  8. Sure:
    – Wage growth had been at or below 4% from 1953-68, but began increasing during 1968 to reach 7% before the first Oil Crisis
    – DeLong says that the problem was that there was a NAIRU, at 4% or higher, from frictional / structural factors (which he can’t explain)…
    – …and that policymakers (scarred by the Great Depression) didn’t yet accept this and so kept trying to force unemployment below 4%, allowing a wage-price spiral to take off.


  9. Thanks Anders,

    What device did policymakers use to “force unemployment below 4%? Note that MMT wishes to provide a government job to anyone who wants one, which presumably would force unemployment to 0%, if unemployment is defined as all people looking for a job.

    I’m not sure I see a clear link between unemployment and inflation.

    Unemployment inflation

    The clearest link I’ve found is to energy prices.

    energy inflation


    1. The unemployment and CPI graph is interesting.

      Looking at the long trends inter-recession, in the 1960’s inflation was increasing as unemployment was falling. This was the heyday of the Phillips Curve. The explanation at the time was the coincidence of the Great Society and the Vietnam War – guns and butter, not one or the other, but both at the same time. Oil was cheap throughout, but we were still on the gold standard, presumably expanding the money supply without sufficiently expanding gold reserves.

      In the 70’s, both unemployment and inflation trended up: stagflation. The worst of both worlds. Soldiers returning to the domestic work force got no jobs and no love. Monetarists blame the inflation on the rapidly increasing Mx, but MMT says it was all due to oil price shocks.

      In the 80’s and 90’s, both unemployment and inflation trended down. This was purported to be the triumph of the monetarists (reversing the errors of 70’s monetary policy, and curing inflation in the early 80’s) and supply-siders, proving the Phillips curve to be wrong.

      In the 2000’s, it’s the 60’s over again: unemployment down, inflation up, but this time only slightly and irregularly. Once again, guns and butter, as two wars drove up spending. The Phillips curve lives again! Was it only temporarily nullified by oil price shocks and by subsequent adjustment to them?

      The apparently changing relationship between these two variables does argue for a theory that explains each of them as a result of some other, separate variable or policy, rather than both being a coordinated result of some one influence. MMT attributes high inflation to the oil price shocks, and variations in unemployment to variations in deficits – two unrelated influences. Is it just a coincidence that sometimes there appears to be a Phillips Curve relationship between these two, and sometimes not?


  10. John,

    Or what really happens is the Fed raises rates to counter actual or anticipated inflation, which is caused by rising oil prices, which is a precursor to recession.

    The notion that a growing Fed Funds rate causes recession would require some correlation between a high FF rate and low GDP growth. I don’t see that. In fact, there actually seems to be a (weak) correlation between high FF rate and high GDP growth.

    See: https://rodgermmitchell.wordpress.com/2009/09/09/low-interest-rates-do-not-help-the-economy/


  11. Yes, the contemporaneous correlation is between high GDP growth (or high GDP level) and high FFR. Just as the contemporary correlation is between high GDP growth/level and low deficits.

    But, just as low/falling deficits are *followed by* recessions, high/rising FFR is *followed by* recession. The causal rationale in both cases requires a time lag.

    I agree the Fed is reacting to actual or anticipated inflation, but the Fed doesn’t believe that oil causes inflation, they believe that they control it. And I think they watch spreads and yield curves to divine inflation expectations, not oil prices.

    How about a graph of FFR and Oil over time?

    BTW, thanks for producing all these graphs. After I switched my major from physics to economics, I was very much attracted to econometrics. I believe MMT has the possibility of making economics more scientific, because it involves stronger policy-oriented mathematical relationships than other models. Graphs help present the data much more coherently (1 picture = 1000 words).


  12. “Just as the contemporary correlation is between high GDP growth/level and low deficits.”

    Not really:


    Reduced deficit growth leads to recessions, and increased deficitill growth causes recoveries from recessions.

    The Fed may believe as you indicate. I have trouble telling what the Fed believes. Sometimes Bernanke hints he may understand Monetary Sovereignty; then he says something that parallels popular belief.

    Because oil prices dictate inflation, and the Fed raises rates to fight inflation, there of course will be a correspondence between increased rates and subsequent decreased oil prices.


    There is a complex relationship between oil prices and interest rates. Oil prices are dictated by Saudi Arabia, more than by any other single factor. So the question becomes: Are there reasons why increasing interest rates might be associated with reduced oil prices?

    Politically, Saudi Arabia is pressed to reduce oil prices. High prices lead to exploration, which leads to greater supply. Also, the U.S., the Saudi’s protector, prefers lower prices.

    I suspect, but can’t prove, that raising rates sends a strong signal to the Saudi’s that prices are too high. So, in addition to affecting the value of money, high interest rates have a political component.

    Interest either fights inflation, is neutral re. inflation or exacerbates inflation. I doubt its neutral. If it exacerbated inflation, we could expect to enter periods were prices and rates form an unending, upward helix, and we don’t find that.

    So, for the above reason, and for money-demand reasons, I am left with the belief that interest rates fight inflation.

    That said, clearly the best way to fight inflation would be to control the price of oil, which might imply a federal takeover of the oil business, either directly or by arm twisting. Interesting thought.

    Today, contrary to popular belief, America is a net exporter of oil, and the government may want to do something about that.


  13. http://research.stlouisfed.org/fredgraph.png?g=4gy

    Shows GDP growing during the shaded (recession) periods. I don’t know what to make of that. I thought the definition of recession was falling GDP, not rising. Is that because the GDP in the graph is nominal, not real, and inflation was a higher number than the absolute value of GDP shrinkage? If you plot real GDP change vs deficit, I think you will see high GDP numbers while the red line (increase in debt) is falling, and lower or negative GDP numbers when it is rising.


    up to 1980, shows FFR rising first, followed by rising energy costs. After 1980, energy cost changes are all over the lot, hard to see any correlation to anything there.

    The 1970’s were a period of “prices and rates form an unending, upward helix”, were they not? I mean, there are wiggles along the way, but a definite trend.

    Anyway, my view is that by whatever mechanism interest rates affect inflation, it is a secondary effect. Large changes in interest rates affect the real economy in a much bigger way.

    I think America is now a net exporter of ENERGY, not of OIL. We export natural gas, as there have been big discoveries here lately, and advances in extraction technology and LNG technology and LNG capacity around the world that has changed gas from a local resource to a global one. Nationalizing the production of oil wouldn’t help control the price much, as we still import quite a lot of our oil consumption.


  14. Rodger – I do concede the correlation between unemployment and inflation is weak. I think the answer to DeLong – and generally, to those who flag the CPI runup in 1968-1973 as having preceded the first oil price shock – has to be that the post-1973 CPI spike should not be seen as a continuation of the 1968-1973 increase, but a separate phenomenon altogether.


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