Inflation

J.W. Mason is an Associate Professor of Economics at City University of New York. He has an interesting comment on the efforts of the US Federal Reserve to control in inflation by raising interest rates.

Today’s macroeconomic orthodoxy puts economic management in the hands of the central bank, which relies mainly on a single instrument, the overnight interest rate between banks. This arrangement is based on a certain model of the economy. In this model, the supply side—the productive capacity of a country’s labor and businesses—grows at a stable pace. Spending, meanwhile, may run ahead or fall behind, depending mainly on developments in the financial system. Asset bubbles may raise desired spending beyond what the economy is able to produce, as businesses take advantage of cheap financing and households of their paper wealth. Bank failures may cut off credit, pushing spending below potential.

If these assumptions hold, then it makes sense that the institution that sits at the apex of the financial system is also the one that manages macroeconomic imbalances like inflation or unemployment.

But the assumptions may not hold. Macroeconomic disturbances may come from the supply side rather than the demand side. Demand may fluctuate for reasons unrelated to finance. Supply and demand may not be independent of each other. Depressed demand can discourage capacity-boosting investment, while strong demand can encourage it.

In these cases, the Fed’s power over the financial system may not be enough to stabilize the economy. Efforts to offset supply disruptions by adjusting the flow of credit somewhere else may fail to address the underlying problems, or even make them worse.