Modern monetary theory and inflation – Part 1

It regularly comes up in the comments section that Modern Monetary Theory (MMT) lacks a concern for inflation. That somehow we ignore the inflation risk. One of the surprising aspects of the public debate as the current economic crisis unfolded was the repetitive concern that people had about inflation. There concerns echoed at the same time as the real economy in almost every nation collapsed, capacity utilisation rates were going down below 70 per cent and more in most nations and unemployment was sky-rocketing. But still the inflation anxiety was regularly being voiced. These commentators could not believe that rising budget deficits or a significant build-up of bank reserves do not inevitably cause inflation. The fact is that in voicing those concerns just tells me they never really understand how the monetary system operates. Further in suggesting the MMT lacks a concern for inflation those making these statements belie their own lack of research. Full employment and price stability is at the heart of MMT. The body of theory and policy applications that stem from that theory integrate the notion of a nominal anchor as a core element. That is what this blog is about.

One recent commentator said:

Bill, do you believe governments should be concerned with price stability at all? Do you believe that fiscal sustainability should have anything to do with the level of inflation (in the MMT world in which monetary policy as we know it does not exist).

In all truth, unless you start seriously talking about inflation and how it will be controlled in a “MMT” economy, I think many minds will remain closed to your ideas.

If your response is simply something along the lines of “unemploment [sic] is a greater problem than inflation, we shouldn’t be too worried about it” it is too easy to dismiss your arguments as idealogically [sic] motivated.

First, unemployment is always a greater problem than inflation in almost any dimension you want to define it and which are calibrated by metrics that different ideological persuasions agree on – such as lost GDP. There is nothing ideological in the statement that the losses from unemployment dwarf those associated with inflation. Even mainstream textbooks struggle to come up with large estimates of the costs of inflation that they itemise.

Even our favourite sham-book – Mankiw’s Principles of Economics – notes that “inflation does not in itself reduce people’s purchasing power”. He lists “shoe leather costs” (walking to the bank more often); “menu costs” (changing catalogues); “confusion and inconvenience” (but “difficult to judge” how severe); “inflation-induced tax distortions” (mainly impacting on returns to saving); and “arbitrary redistributions of wealth” (if inflation suddenly changes) but the estimated losses arising are nothing like those attributed to persistent unemployment.

There has been no credible study that shows that overall the losses from these “costs” amount to millions of dollars of foregone output every day. There is ample evidence that mass unemployment results in huge permanent losses every day in foregone output and income.

And then if you study the broader literature (health, mental health, sociology, crime, family studies etc) you realise that the macroeconomic losses from unemployment are just the tip of the iceberg. The personal, family and community losses are very large and persist across generations.

Second, embedded in MMT is a concern for price stability. It is one of the first principles of fiscal sustainability. The models developed provide innovative solutions to the twin evils of unemployment and inflation, even if we recognise as an empirical fact (independent of our ideologies) that unemployment is a much more significant evil.

I have written extensively about inflation – in my academic work and in many blogs. In my recent book with Joan Muysken – Full Employment abandoned – we considered inflation as a central concept. In my PhD work, unemployment and inflation were the central themes. My contribution to the development of MMT over many years has been focused on inflation as a primary concern.

So at the risk of repetition, here is some more on inflation.

What is inflation?

In this blog I am only considering inflationary pressures that arise from nominal demand (spending) growth outstripping the real capacity of the economy to react to it with output responses. In other words, I am excluding inflation that may arise from supply shocks – such as a rise in an imported raw material (for example, oil). That is another issue altogether.

The reason I am excluding supply-driven inflationary impulses is because the mainstream attack on the current use fiscal policy (and monetary policy) is really about demand pressures. We are continually reading crude statements such as there is “too much money” in the system.

Further, the mechanisms through which the supply shocks manifest are different and this deserves a separate analysis, which will come in a subsequent blog (Inflation Part 2).

However, the solution to both sources of inflation is not that dissimilar although additional measures might be brought to bear to handle the case of a price hike in an imported raw material.

First we should make sure what we are talking about. Many conservative commentators think that when workers get a pay rise it is inflation. It is not. Those on the left think that when the corporate sector increase the price of a good or service it is inflation. It is not.

It is also not inflation when the exchange rate falls pushing the price of imports up a step. So a depreciation in the currency does not constitute inflation. It might stimulate inflation but is not in itself inflation.

It is also not inflation when the government increases a particular tax (say the VAT or GST) by x per cent to some new level.

So while a price rise is a necessary condition for inflation it is not a sufficient condition. Observing a price rise alone will not be sufficient to categorise the phenomena that you are observing as being an inflationary episode.

Inflation is the continuous rise in the price level. That is, the price level has to be rising each period that you observe it. So if the price level or a wage level rises by 10 per cent every month, then you have an inflationary episode. In this case, the inflation rate would be considered stable – a constant rise per period.

If the price level was rising by 10 per cent in month one, then 11 per cent in month two, then 12 per cent in month three and so on, then you have accelerating inflation. Alternatively, if the price level was rising by 10 per cent in month one, 9 per cent in month two etc then you have falling or decelerating inflation.

If the price level starts to continuously fall then we call that a deflationary episode.

Hyper-inflation is just inflation big-time!

So a price rise can become inflation but is not necessarily inflation. Many commentators and economists get this basic understanding wrong – often and continually.

Second, it also follows that cyclical adjustments in price levels by firms from what they are currently offering at depressed levels of activity to what the price levels that are defined at their normal operating capacity levels are not inflation. When the economy is in poor shape, firms cut prices in an attempt to increase capacity utilisation by temporarily suppressing their profit margins and hence maintain market share. As demand conditions become more favourable the firms start increasing the prices they offer until they get back to those levels that offer them the desired rate of return at normal capacity utilisation.

Firms are basically quantity adjusters if they have spare capacity. They will seek to maintain market share when nominal demand grows by increasing output where possible. Should nominal demand growth (supported in part by net public spending) outstrip this capacity then firms will become price adjusters, because they can no longer expand real output.

Bottlenecks in some sub-markets may occur before other sectors are at full capacity and so price pressures might emerge just before overall full capacity is reached. So, in reality, the aggregate supply response (which tells you how much real output will be forthcoming at each price level) may not be strictly reverse-L shaped (where price is on the vertical axis and output on the horizontal axis). The extent to which the reverse-L becomes a curve at at a point approaching full capacity is an empirical matter.

Inflation occurs when there is chronic excess demand relative to the real capacity of the economy to produce.

Buffer stocks and price stability

MMT provides a broad theoretical macroeconomic framework based on the recognition that fiat currency systems are in fact public monopolies per se, and introduce imperfect competition to the monetary system itself, and that the imposition of taxes coupled with insufficient government spending generates unemployment in the private sector.

An understanding of MMT allows us to appreciate how unemployment occurs and to detail the role that government can play in maintaining its near universal dual mandates of price stability and full employment. My work on this goes back to my early writings in 1978!

Please read my blog – Functional finance and modern monetary theory – as an introduction to this material.

There are two broad ways to control inflation and buffer stocks are involved in each:

  • Unemployment buffer stocks: Under a mainstream NAIRU regime (the current orthodoxy), inflation is controlled using tight monetary and fiscal policy, which leads to a buffer stock of unemployment. This is a very costly and unreliable target for policy makers to pursue as a means for inflation proofing.
  • Employment buffer stocks: The government exploits the fiscal power embodied in a fiat-currency issuing national government to introduce full employment based on an employment buffer stock approach. The Job Guarantee (JG) model which is central to MMT is an example of an employment buffer stock policy approach.

Under a Job Guarantee, the inflation anchor is provided in the form of a fixed wage (price) employment guarantee.

Full employment requires that there are enough jobs created in the economy to absorb the available labour supply. Focusing on some politically acceptable (though perhaps high) unemployment rate is incompatible with sustained full employment.

Under the neo-liberal policy regime, central banks have, increasingly, been given the responsibility by government for managing the price level. In conducting monetary policy to fulfill their major economic objectives, central banks manipulate the interest rate and attempt to manage the state of inflation expectations.

These policy tools are employed to achieve an “optimal” level of price stability and capacity utilisation (typically assumed to be invariant in the long-run to nominal aggregates). Where negative real effects from the operation of inflation-first monetary policy are acknowledged they are theorised to be necessary for optimal long term growth and employment and small in magnitude.

These considerations suggest that the central bank, as part of the consolidated currency-issuing government sector, has another, somewhat similar yet far more effective buffer stock option which is in fact an alternative way of managing the unemployment program.

In MMT, a superior use of the labour slack necessary to generate price stability is to implement an employment program for the otherwise unemployed as an activity floor in the real sector, which both anchors the general price level to the price of employed labour of this (currently unemployed) buffer and can produce useful output with positive supply side effects.

The employment buffer stock approach (the JG) exploits the imperfect competition introduced by fiat (flexible exchange rate) currency which provides the issuing government with pricing power and frees it of nominal financial constraints.

The JG approach represents a break in paradigm from both traditional Keynesian policies and the NAIRU-buffer stock approach. The difference is a shift from what can be categorised as spending on a quantity rule to spending on a price rule.

For example, under current policy, the government generally budgets a quantity of dollars to be spent at prevailing market prices. In contrast, with the JG option, the government additionally offers a fixed wage to anyone willing and able to work, and thereby lets market forces determine the total quantity of government spending. This is what I call spending based on a price rule.

Under the JG scheme, the government continuously absorbs workers displaced from private sector employment. The JG workers thus constitute a buffer employment stock and would be paid the minimum wage.

Many economists who are sympathetic to the goals of full employment are sceptical of the JG approach because they fear it will make inflation impossible to control. To answer these claims, I once again outline the inflation control mechanisms inherent in the JG model. If the private sector is inflating, a tightening of fiscal and/or monetary policy shifts workers into the fixed-wage JG-sector to achieve inflation stability without unemployment.

Unemployment buffer stocks and price stability

There have been two striking developments in economics over the last thirty years. First, a major theoretical revolution has occurred in macroeconomics (from Keynesianism to Monetarism and beyond) since the mid 1970s. Second, unemployment rates have persisted at the highest levels known in the Post World War II period and in the current crisis have sky-rocketed upwards.

The concept of full employment as a genuine policy goal was abandoned with introduction of the natural rate of unemployment hypothesis (Friedman and Phelps) which has became a central plank of current mainstream thinking.

It asserts that there is only one unemployment rate consistent with stable inflation. In the natural rate hypothesis, there is no discretionary role for aggregate demand management and only microeconomic changes can reduce the natural rate of unemployment. Accordingly, the policy debate became increasingly concentrated on deregulation, privatisation, and reductions in the provisions of the Welfare State with tight monetary and fiscal regimes instituted.

The almost exclusive central bank focus on maintaining price stability on the back of an overwhelming faith in the NAIRU ideology has marked the final stages in the evolution of an abandonment of earlier full employment policies.

The modern policy framework is in contradistinction to the practice of governments in the Post World War II period to 1975 which sought to maintain levels of demand using a range of fiscal and monetary measures that were sufficient to ensure that full employment was achieved. Unemployment rates were usually below 2 per cent throughout this period.

Under inflation targeting (or inflation-first) monetary regimes, central banks shifted their policy emphasis. They now conduct monetary policy to meet an inflation target and, arguably, have abandoned any obligations they have to support a policy environment which achieves and maintains full employment. Unemployment since the mid-1970s has mostly persisted at high levels although in some economies low quality, casualised work has emerged in the face of persistently deficient demand for labour hours.

However, central bankers do not characterise their approach in this way and they avoid recognition of the empirical fact that contractionary monetary policy continues to generate output and employment losses which are permanent. Instead the dominant paradigm suggests that full employment is a natural derivative of the maintenance of price stability even though this approach to price stability requires the maintenance of an unemployed buffer stock.

The use of unemployment as a tool to suppress price pressures has, based on the OECD experience in the 1990s, been successful in that inflation is now no longer driven by its own expectations. One explanation is that unemployment temporarily balances the conflicting demands of labour and capital by disciplining the aspirations of labour so that they are compatible with the profitability requirements of capital.

Similarly, low product market demand, the analogue of high unemployment, suppresses the ability of firms to pass on prices to protect real margins. Other explanations for the effectiveness of unemployment in controlling inflation are possible.

The empirical evidence is clear that most OECD economies have not provided enough jobs since the mid-1970s and the conduct of monetary policy has contributed to the malaise. Central banks around the world have forced the unemployed to engage in an involuntary fight against inflation and the fiscal authorities in many cases have further worsened the situation with complementary austerity.

How useful is the NAIRU as a guide to policy? There is a growing literature that shows that the NAIRU is useless as a guide to policy.

Please read my blog – The dreaded NAIRU is still about! – for more discussion on this point.

While there may be some stability between inflation and unemployment for a period, experience from many OECD countries suggests that a sudden shock, especially from the supply side (as in 1974) can worsen the unemployment resulting from a deflationary strategy, which is attempting to exploit a given Phillips curve.

Evidence from the OECD experience since 1975 suggests that deflationary policies are effective in bringing inflation down but impose huge costs on the economy and certain demographic groups, which are rarely computed or addressed.

The overwhelming quandary that the NAIRU approach to inflation control faces is whether the economy, once deflated by restrictive aggregate demand management, can be restarted without inflation.

If the underlying causes of the inflation are not addressed a demand expansion will merely reignite the tensions and a wage-price outbreak is likely. As a basis for policy the NAIRU approach is thus severely restrictive and provides no firm basis for full employment and price stability.

Further, despite its centrality to policy, the NAIRU evades accurate estimation and the case for its uniqueness and cyclical invariance is weak. Given these vagaries, its use as a policy tool is highly contentious.

Employment buffer stocks and price stability

It is clear that central bankers are now using buffer stocks of unemployed to achieve a desirable price level outcome. While the real effects of such a policy have been contested, there is overwhelming evidence to suggest that the cumulative costs of this strategy in real terms have been substantial.

Several researchers have found that sacrifice ratios remain significant and persistent, meaning that GDP losses during disinflation episodes are substantial. Additionally, a major component of this monetary policy stance is the persistent pool of unemployed (and other forms of labour underutilisation, for example, underemployment) as a buffer stock for wage and thereby price stability.

Please read my blog – The Great Moderation myth – for more discussion on this point.

In addition to lost output, other real costs are suffered by the nation, including the depreciation of human capital, family breakdowns, increasing crime, and increasing medical costs.

So the unemployment pool is thus widely recognised and monitored as a price anchor, a primary concern for price stability in general, and a prime object of monetary policy. However, the effectiveness of an unemployed buffer stock has been shown to deteriorate over time, with ever larger numbers of fresh unemployed or underemployed required to function as a price anchor that stabilises wages.

So in recognising that the effectiveness of unemployment per se as a price anchor is a further function of the terms, conditions, and administration of the unemployment program, MMT recommends management of the unemployment policy and programs be made a function of the agency responsible for said price stability – the central bank.

The question that arises is whether using a persistent pool of unemployed (or casualised underemployed) is the most cost effective way to achieve price stability?

An understanding of MMT principles suggest that a better alternative would be to utilise an employed buffer stock approach which is in fact an alternative way of managing the unemployment program.


The concept of a Job Guarantee

In this vein we are suggesting that politicians should set a minimum acceptable living standard and ensure that a base level job is always available to allow all citizens to achieve that living standard independent of welfare payments. This is the essence of the JG. Analogous to the central bank’s function of lender of the last resort, the JG functions as a buffer which absorbs all potential employment, at the accepted minimum wage. Government then is also the employer of the last resort.

An additional advantage is that by creating an employment buffer stock government also facilitates inflation control.

Please read my blog – When is a job guarantee a Job Guarantee? – for a detailed introduction to the JG concept.

While it is easy to characterise the JG as purely a public sector job creation strategy, it is important to appreciate that it is actually a macroeconomic policy framework designed to deliver full employment and price stability based on the principle of buffer stocks where job creation and destruction is but one component.

The idea came to me in 1978 when I was studying agricultural economics at the University of Melbourne. My earlier works discusses the link between the JG approach and the agricultural price support buffer stock schemes like the Wool Floor Price Scheme introduced by the Australian Government in 1970.

This was a system where the government desired to stabilised farm incomes and so agreed on a price for wool with the farmers. The government would then purchase excess wool supplied into the market to ensure the agreed price was maintained and in better times sell wool. They kept the wool in big stores spread all around the country.

So the government held buffer stocks of wool to manage the price. The JG is a buffer stock scheme too.

While generating full employment for wool production, there was an issue of what constituted a reasonable level of output in a time of declining demand.

The argument is not relevant when applied to unemployed labour. If there is a price guarantee below the prevailing market price and a buffer stock of working hours constructed to absorb the excess supply at the current market price, then a form of full employment can be generated without tinkering with the price structure.

The other problem with commodity buffer stock systems is that they encouraged over-production, which ultimately made matters worse when the scheme were discontinued and the product was dumped onto the market. These objections to do not apply to maintaining a labour buffer stock as no one is concerned that employed workers would have more children than unemployed workers.

Benjamin Graham wrote in the 1930s about the idea of stabilising prices and standards of living by surplus storage. He documents how a government might deal with surplus production in the economy. He said the:

State may deal with actual or threatened surplus in one of four ways: (a) by preventing it; (b) by destroying it; (c) by “dumping” it; or (d) by conserving it.

In the context of an excess supply of labour, governments now choose the dumping strategy via the NAIRU. It makes much better sense to use the conservation approach via a JG. Graham (1937: 34) noted:

The first conclusion is that wherever surplus has been conserved primarily for future use the plan has been sensible and successful, unless marred by glaring errors of administration. The second conclusion is that when the surplus has been acquired and held primarily for future sale the plan has been vulnerable to adverse developments …

The distinction is important in the JG model. The Australian Wool Scheme was an example of storage for future sale and was not motivated to help the consumer of wool but the producer.

The JG policy is an example of storage for use where the “reserve is established to meet a future need which experience has taught us is likely to develop” (Graham, 1937: 35).

Graham also proposed a solution to the problem of interfering with the relative price structure when the government built up the surplus. In the context of the JG policy, this means setting a JG wage below the private market wage structure. To avoid disturbing the private sector wage structure and to ensure the JG is consistent with price stability, the JG wage rate should probably be set at the current legal minimum wage, though an initially higher JG wage may be offered if the government sought to combine the JG policy with an industry policy designed to raise productivity.

Under the JG, the public sector offers a fixed wage job, which we consider to be price rule spending, to anyone willing and able to work, thereby establishing and maintaining a buffer stock of employed workers. This buffer stock expands (declines) when private sector activity declines (expands), much like today’s unemployed buffer stocks, but potentially with considerably more liquidity if properly maintained.

The JG thus fulfills an absorption function to minimise the real costs currently associated with the flux of the private sector. When private sector employment declines, public sector employment will automatically react and increase its payrolls.

The nation always remains fully employed, with only the mix between private and public sector employment fluctuating as it responds to the spending decisions of the private sector. Since the JG wage is open to everyone, it will functionally become the national minimum wage.

Inflation control under a Job Guarantee

The fixed JG wage provides an in-built inflation control mechanism. In an earlier published paper I called the ratio of JG employment to total employment the Buffer Employment Ratio (BER).


Ultimately this attenuates the inflation spiral. So instead of a buffer stock of unemployed being used to discipline the distributional struggle, the JG policy achieves this via compositional shifts in employment. That is it can also deal with a supply-shock that generates distributional demands that ultimately cause inflation.

The BER that results in stable inflation is called the Non-Accelerating-Inflation-Buffer Employment Ratio (NAIBER). It is a full employment steady state JG level, which is dependent on a range of factors including the path of the economy.

A plausible story to show the dynamics of a JG economy compared to a NAIRU economy would begin with an economy with two labour sub-markets: A (primary) and B (secondary) which broadly correspond to the dual labour market depictions. Prices are set according to mark-ups on unit costs in each sector.

Wage setting in A is contractual and responds in an inverse and lagged fashion to relative wage growth (A/B) and to the wait unemployment level (displaced Sector A workers who think they will be re-employed soon in Sector A).

A government stimulus to this economy increases output and employment in both sectors immediately. Wages are relatively flexible upwards in Sector B and respond immediately.

The compression of the A/B relativity stimulates wage growth in Sector A after a time. Wait unemployment falls due to the rising employment in A but also rises due to the increased probability of getting a job in A. The net effect is unclear.

The total unemployment rate falls after participation effects are absorbed. The wage growth in both sectors may force firms to increase prices, although this will be attenuated somewhat by rising productivity as utilisation increases. A combination of wage-wage and wage-price mechanisms in a soft product market can then drive inflation. This is a Phillips curve world.

To stop inflation, the government has to repress demand. The higher unemployment brings the real income expectations of workers and firms into line with the available real income and the inflation stabilises – a typical NAIRU story.

Introducing the JG policy into the depressed economy puts pressure on Sector B employers to restructure their jobs in order to maintain a workforce. For given productivity levels, the JG wage constitutes a floor in the economy’s cost structure. The dynamics of this economy change significantly.

The elimination of all but wait unemployment in Sector A and frictional unemployment does not distort the relative wage structure so that the wage-wage pressures that were prominent previously are now reduced.

The wages of JG workers (and hence their spending) represents a modest increment to nominal demand given that the state is typically supporting them on unemployment benefits. It is possible that the rising aggregate demand softens the product market, and demand for labour rises in Sector A.

But there are no new problems faced by employers who wish to hire labour to meet the higher sales levels in this environment. They must pay the going rate, which is still preferable, to appropriately skilled workers, than the JG wage level. The rising demand per se does not invoke inflationary pressures if firms increase capacity utilisation to meet the higher sales volumes.

With respect to the behaviour of workers in Sector A, one might think that the provision of the JG will lead to workers quitting bad private employers. It is clear that with a JG, wage bargaining is freed from the general threat of unemployment.

However, it is unclear whether this will lead to higher wage demands than otherwise. In professional occupational markets, some wait unemployment will remain. Skilled workers who are laid off are likely to receive payouts that forestall their need to get immediate work.

They have a disincentive to immediately take a JG job, which is a low-wage and possibly stigmatised option. Wait unemployment disciplines wage demands in Sector A. However, demand pressures may eventually exhaust this stock, and wage-price pressures may develop.

A crucial point is that the JG does not rely on the government spending at market prices and then exploiting multipliers to achieve full employment which characterises traditional Keynesian pump-priming. Traditional Keynesian remedies fail to provide an integrated full employment-price anchor policy framework. In fact, a Keynesian policy agenda would impact more significantly on inflation if it was true that a JG was inflationary as a result of its impacts on demand in the product market.

Would the NAIBER will be higher than the NAIRU?

This last point invokes a fierce debate as to relative sizes of the NAIBER vis-à-vis the NAIRU. Some commentators argue that the NAIBER would have to be greater than the NAIRU for an equivalent amount of inflation control.

There are two strands to this argument. First, the intuitive but somewhat inexact view is that because JG workers will have higher incomes (than when they were unemployed) a switch to this policy would always see demand levels higher than under a NAIRU world.

As a matter of logic then, if the NAIRU achieved output levels commensurate with price stability then, other things equal, a higher demand level would have to generate inflationary impulses. So according to this view, the level of unemployment associated with the NAIRU is intrinsically tied to a unique level of demand at which inflation stabilises.

Second, and related, it is claimed that the introduction of the JG reduces the threat of unemployment which serves to discipline the wage setting process. The main principle of a buffer stock scheme like the JG is straightforward – it buys off the bottom (at zero bid) and cannot put pressure on prices that are above this floor. The choice of the floor may have once-off effects only.

It should be noted that while it is clear that JG workers will enjoy higher purchasing power under a JG compared to their outcomes under a NAIRU policy, it is not inevitable that aggregate demand overall would rise with the introduction of JG.

But assuming aggregate demand is higher when the JG is introduced than that which prevailed in the NAIRU economy, a traditional economist (and some Post Keynesians) might wonder why inflation is not inevitable as we replace unemployment with (higher paying) employment.

Rising demand per se does not necessarily invoke inflationary pressures because by definition, given the logic developed in Chapter 8, the extra liquidity is satisfying a net savings desire by the private sector.

Additionally, in today’s demand constrained economies, firms are likely to increase capacity utilisation to meet the higher sales volumes. Given that the demand impulse is less than required in the NAIRU economy, it is clear that if there were any demand-pull inflation it would be lower under the JG. So there are no new problems faced by employers who wish to hire labour to meet the higher sales levels.


The impact on the price level of the introduction of the JG will also depend on qualitative aspects of the JG pool relative to the NAIRU unemployment buffer. It is here that the so-called threat debate enters.

The JG buffer stock is a qualitatively superior inflation fighting pool than the unemployed stock under a NAIRU. Therefore the NAIBER will be lower than the NAIRU which means that employment can be higher before the inflation barrier is reached.

In the NAIRU logic workers may consider the JG to be a better option than unemployment. Without the threat of unemployment, wage bargaining workers then may have less incentive to moderate their wage demands notwithstanding the likely disciplining role of wait unemployment in skilled labour markets.

However, when wait unemployment is exhausted private firms would still be required to train new workers in job-specific skills in the same way they would in a non-JG economy.

Further, JG workers are far more likely to have retained higher levels of skill than those who are forced to succumb to lengthy spells of unemployment. It is thus reasonable to assume that an employer would consider a JG worker, who is already demonstrating commitment to working, a superior training prospect relative to an unemployed and/or hidden unemployed worker. This changes the bargaining environment rather significantly because the firms now have reduced hiring costs. Previously, the same firms would have lowered their hiring standards and provided on-the-job training and vestibule training in tight labour markets.

The functioning and effectiveness of the buffer employment stock is critical to its function as a price anchor. Condition and liquidity is the key. Just as soggy rotting wool is useless in a wool price stabilisation scheme, labour resources should be nurtured as human capital constitutes the essential investment in future growth and prosperity.

There is overwhelming evidence that long-term unemployment generates costs far in excess of the lost output that is sacrificed every day the economy is away from full employment. It is clear that the more employable are the unemployed the better the price anchor will function.

The JG policy thus would reduce the hysteretic inertia embodied in the long-term unemployed and allow for a smoother private sector expansion. Therefore JG workers would constitute a credible threat to the current private sector employees. When wage pressures mount, an employer would be more likely to exercise resistance if she could hire from the fixed-price JG pool.

As a consequence, longer term planning with cost control would be enhanced. So in this sense, the inflation restraint exerted via the NAIBER is likely to be more effective than using a NAIRU strategy.

Another associated factor relates to the behaviour of professional occupational markets. In those markets, while any wait unemployment will discipline wage demands, the demand pressures may eventually exhaust this stock and wage-price pressures may develop.

With a strong and responsive tertiary education sector combined with strong firm training processes skill bottlenecks can be avoided more readily under the JG than with an unemployed buffer stock in place. The JG workers would be already maintaining their general skills as a consequence of an on-going attachment to the employed workforce.

The qualitative aspects of the unemployed pool deteriorate with duration making the transition back in the labour force more problematic. As a consequence, the long-term unemployed exert very little downward pressure on wages growth because they are not a credible substitute.

Responsible fiscal practice in MMT

This is the macroeconomic sequence that defines responsible fiscal policy practice in MMT. This is basic macroeconomics and the debt-deficit-hyperinflation neo-liberals seem unable to grasp it:



3. The sovereign government can purchase any real good or service that is available for sale in the market at any time. It never has to finance this spending unlike a household which uses the currency issued by the sovereign government. The household always has to finance its spending (as do state and local governments in a federal system).

4. The non-government sector typically decides (in aggregate) to save a proportion of the income that is flowing to it. This desire to save motivates spending decisions which result in the flow of spending being less than the income produced. If nothing else happened then firms would reduce output and income would fall (as would employment) and households would find they were unable to achieve their desired saving ratio.

5. The government sector must in this situation fill the spending gap left by the non-government sector’s decision to withdraw some spending (in relation to its income). If the government does increase its net contribution to spending (that is, run a budget deficit) up to the point that total spending now equals total income then firms will realise their planned output sales and retain current employment levels.

6. The government sector’s net position (spending minus revenue) is the mirror image of the non-government’s net position. So a government surplus is equal $-for-$, cent-for-cent to a non-government deficit and vice versa. So if the non-government sector is in surplus (a net saving position) then income adjustments will render the government sector in deficit whether it plans to be in that state or not. If income is falling in the face of rising saving behaviour of the non-government sector and that spending gap is not filled by government net spending then the budget deficit will rise (as income adjustments cause tax revenue to fall and welfare payments to rise). You end up with a deficit but the economy is at a much less satisfactory position than would have been the case if the government had have “financed” the non-government saving desire in the first place and kept employment levels high.

7. A fiscally-responsible government will attempt to maintain spending levels sufficient to fill any saving but not push nominal aggregate spending beyond the full capacity level of output.


Given the overwhelming central bank focus on price stability, and the critical roll of today’s unemployed buffer stocks of unemployed, we argue that functioning and effectiveness of the buffer stock is critical to its function as a price anchor.

Condition and liquidity are the keys. Just as soggy rotting wool is useless in a wool price stabilisation scheme, labour resources should be nurtured as human capital constitutes the essential investment in future growth and prosperity. There is overwhelming evidence that long-term unemployment generates costs far in excess of the lost output that is sacrificed every day the economy is away from full employment.

It is clear that the more employable are the unemployed the better the price anchor will function. The government has the power to ensure a high quality price anchor is in place and that continuous involvement in paid-work provides returns in the form of improved physical and mental health, more stable labour market behaviour, reduced burdens on the criminal justice system, more coherent family histories and useful output, if well managed.

It is also the case the training in a paid-work environment is more effective than contextually isolated training schemes, which have become the fashion under the active labour market programs pursued by governments in all countries over the last two decades.

Now don’t say MMT doesn’t integrate a concern for inflation at the level of first principles.

That is enough for today!

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    109 Responses to Modern monetary theory and inflation – Part 1

    1. Sergei says:

      stone, silver/gold/copper/oil/etc. prices are results of speculation in futures market where about 2-3% of all futures reach physical delivery. No economic theory will tell you what to do because this issue is outside of any economic theory. It is not science. And the way to solve it is not to make it science but to call things the way they are. It is not about taxing silver market and not taxing gold market. Or taxing it today but not tomorrow.

    2. RSJ says:

      Bill, I am confused by this statement:


      Later on, you refer to fiscal and monetary policy as controlling inflation, which suggests that these are the tools used by government to control inflation, rather than the JG.

      If there is an anchor, the workings of this channel remains mysterious. I can imagine a variety of scenarios by which the JG wage is $10, the “labor output” per JG worker is $11, and yet the economy is experiencing raging inflation, or raging deflation, because at a minimum you care about overall unit labor costs and labor productivity, rather than just the JG unit labor costs and JG productivity.

      On top of that there are distributional effects, credit effects, terms of trade effects, etc., none of which can be “anchored” by JG, but all of which are important determinants of inflation.

    3. Nathanael says:


      Don’t you mean shifts workers OUT OF the fixed-wage JG-secotr into the private sector?

    4. Nathanael says:

      OK, wait, no, I see it. To break a wage-price spirral, you advise a neoclassical tightening of monetary policy — issuing Treasury bonds (for example) at high rates to deliberately drive out private investment — or a neoclassical tightening of fiscal policy — firing highly-paid workers, shutting down parts of the government sector — while driving said people into the fixed-wage JG sector.

      That doesn’t seem good.

      Surely it is better to accept a wage-price spiral as many South American countries did. As long as it results in high but stable inflation, the best reaction is “who cares?” It ends up being a transfer from rich to poor and from creditor to debtor, which is desirable in any case.

      Alternatively, how about breaking the pricing power of capital with an excess profits tax, thus preventing them from passing on wage increases as price increases. That would be fiscal policy, I guess.

      I keep coming back to distributional issues. MMT analysis doesn’t eliminate the fundamental fact that wealth and income inequality are the drivers of all our problems; if anything, it makes it even more blatant. Only redistribution of wealth can create a stable economy (and there is AMPLE evidence for this, historically — the problem is that a society with a stable economy with a fairly equal distribution of wealth tends to “forget” why it needed an equal distribution of wealth, over the course of several generations, and then is easy pickings for kleptocrats — and there’s some evidence for that too.)

    5. Nathanael says:

      Joe Firestone, I have to agree with your political reading, but I’ll point out that Carter was far ahead of his time and very ideological when it came to one thing: the environment. Unfortunately, only a subset of Democrats have adopted the care of the ecology which supports our lives as the ideological crusade to replace the former “work and industry and jobs” policy of the Democratic Party. Ecological protection is a damned good ideology, and the only one which will keep our species from going extinct in the next dozen generations, so I’d take that as a substitute for any previous ideology. But we aren’t even getting that from our Clinton/Obama era Democrats — we really are getting non-ideological “give in to anyone” politics.

    6. bill says:

      Dear Nathanael (at 2011/04/02 at 1:31)

      Don’t you mean shifts workers OUT OF the fixed-wage JG-sector into the private sector?

      No I mean INTO the JG sector. If the government buys at a fixed price it cannot be inflationary.

      best wishes

    7. HarPe says:

      I have a question! I might’ve missed the answer in some blog-entry, so if someone knows which one, i’d love for them to link it to me.

      Anyway, the question is: Doesn’t interest rates increase the general demand for money in the private sector? Say, in a “stagflationary” episode, what would the result be if interest rates were increased quite a bit at the same time as fiscal stimulus was applied through various means?

      I mean, i agree monetary policy is crap for stimulating growth and interest rates shouldn’t be tampered with that often, but wouldn’t an increased cost of capital increase demand for the currency?


    8. HarPe says:

      Oh, and what about using bonds as a means to maintain demand for the currency, as opposed to reducing it’s supply? I mean, bonds are pretty much the best low-risk investment there is, aren’t they?


    9. Stanley Mulaik says:

      Here is a letter I sent to President Obama earlier this week:

      Mr. President:

      Thank you for your letter of June 14. I’ll try to make this as brief as I can.

      In your letter to me you said that “Democrats and Republicans were trying to reduce the Federal deficit by more than $2.5 trillion—mostly through spending cuts, but also by raising tax rates on the wealthiest 1 percent Americans.”

      With all due respect, according to Modern Monetary Theory (MMT), which I am a student of, this is just the opposite of what our Federal government should be trying to do in this recession. This policy will lead to increased unemployment and a deeper recession.

      Modern Monetary Theory is the description and theory of how our fiat money system works.

      My understanding of MMT is that the nation’s economy consists of a central arena in which money flows chasing goods and services in economic exchanges between parties. Think of it as like a swimming pool. The amount of money in the pool represents a certain amount of goods and services that may be bought and sold with money in circulation. The money circulates from buyer to seller to buyer, etc.

      There are several inputs of money into the pool and several outputs. Inputs to the pool are government spending, investments drawn from savings, export earnings, and purchases of bonds from banks by the Fed (which creates the money out of nothing when it buys), and loans created out of nothing by private banks and lent. (Banks do not lend their depositor’s money, contrary to popular myth subscribed to by many main stream economists. They count their deposits as their 10% of reserves).

      There are several outputs from the pool that drain the pool, reducing the amount of money circulating in the pool. These are taxes (which take money out of circulation if not respent), savings (which end up in bank vaults), imports (e.g. buy at WalMart or Target and send money out of country, buy oil and gasoline from foreign producers), Fed sells bonds and securities to banks to drain the money in their reserves, borrowers repay banks for loans which extinguishes debt.

      The major issues of fiat money use are inflation and recessions.

      Inflations occur when more money flows into the central pool than there are goods and services to absorb them at current prices. If money enters endlessly, hyperinflation can occur.

      Deflations occur when there is less money in the pool to clear all the goods and services produced at current prices. Prices fall to clear the goods. Wages are reduced as businesses cut back, laying off workers, because of lowering demand. Debtors suffer because their debts do not fall with the increase in value of the money.

      The task of a central government with fiat money is to insure that enough money is circulating in the pool to clear all goods and services with full employment and stable prices. It seeks to adjust inputs and outputs from the pool to a point where enough money remains in the pool to absorb all goods and services at stable prices with full employment.

      If excess money is entering circulation (from whatever sources) when economy is in full production and employment, the excess must be drained or result in inflation. This can be accomplished in several ways: (1) taxes can be raised but not spent. (2) government can cut back on its spending, especially deficit spending. (3) buying imports can be encouraged. (4) government (Treasury and Fed) can sell bonds to take money out of circulation. (5) Fed can raise interest rates to discourage investment from savings and borrowing.

      If an insufficient amount of money is in circulation in the pool, then a recession or depression results. (1) Taxes need to be reduced to keep more money in circulation. (2) Deficit spending on projects serving the general welfare, like infrastructure, education, and health is needed to increase demand and increase money in circulation: Treasury issues securities and sells them to banks to borrow money for the deficit. Ultimately the Fed buys these securities from banks to restore their reserves and increase lending. Fed buys these securities by creating new money and introducing that into the banking system, in hopes the banks will lend it into circulation. Fed’s purchase of securities redeems debt of government to banks. (But securities should still be live at the Fed if not mature and Fed can swap mature securities with Treasury for new immature securities. Money supply is increased by the money created and issued to banks’ reserves to purchase securities. Fed lowers interest rate so banks and private borrowers will borrow, and savers will see more gains in investments in productive activities. Government raises tariffs to discourage imports (which drain money from circulation). Government spending on education, scientific research also leads to innovation and export sales, which increase money from foreign buyers of our goods and services.

      Once you see how the amount of money in circulation chasing goods and services depends on multiple inputs and outputs, you will see that in our current economy raising taxes and cutting deficits is just the opposite of what should be done to get out of the recession. While the top 1% have lots of money in savings and not in circulation, they still have a lot invested in various projects. If we raise taxes on them and spend it but do not correspondingly introduce new money into circulation from some source, nothing is changed in how much money is in the circulating pool. Their investing in projects is cancelled by the amount of taxes taken from them. (We do not tax savings, only interest earnings from savings, capital gains, and distributions from tax exempt income like in 401k plans).

      Cutting deficit spending more seriously reduces the amount of money in circulation, and in a recession this is bad policy. It does not increase the amount of money already in circulation. Unless there is some increase in another input source of money for the circulating pool, the effect will reduce the amount of money in the pool. Moving money around in the budget does not increase the money supply in circulation which is needed to fight the recession. Seeking continuing surpluses will take money endlessly out of circulation causing a depression unless balanced by increases in other inputs.

      You might wonder why during all the deficit spending on the wars in Iraq and Afghanistan, we have not had serious inflation. We don’t sell lots of bonds like in World War II. So, why can we do this without inflation? I think we need to look at the imports we buy. Buying oil from Arabs and household goods from China in great quantities balances to some extent the deficits. Fiscal policy that concerns just taxes and government spending is inadequate for understanding a complex economy like we have. We have to look at all the inputs and all the outputs, and see what combinations of them in various quantities will lead to a “balanced” pool of circulating money chasing goods at stable prices with full employment.

      I’m expecting the sequestration to really cut in later this summer as the various cuts take effect. Reducing $85 billion from the budget may be like reducing $850 billion in circulation due to the reductive multiplier effect. And if your other budget cuts in spending take effect also, that will hurt more as well. So we may be heading into a deeper recession by the end of this year. Franklin Delano Roosevelt had a similar recession in 1937-1938, because he was listening to austerity advice from Treasury and the banks.

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