A missing element in the empirical post Keynesian theory of inflation—total credits to households: A first-differenced VAR approach to U.S. inflation

Abstract

This paper analyzes U.S. inflation since the early 1980s, using the post Keynesian theory of inflation. Our empirical model that contains both supply- and demand-side variables is run over the total sample and the recent subsample after we notice a structural break in 2000Q3. The empirical results of the generalized impulse response analysis based on the estimated vector autoregression suggests that supply-side variables are significant in explaining U.S. inflation regardless of time, whereas the demand-side variable, the excess credit creation/depletion of households, is only crucial in the recent period. It demonstrates a missing element in the empirical post Keynesian theory of inflation. Furthermore, it is found that current monetary policy tools of maneuvering target interest rates and controlling monetary supply is not effective to their policy goals toward price stability.

Keywords:

• Inflation
• households credit
• VAR

JEL CLASSIFICATIONS::

• E12
• E31

Notes

1 See, for example, Wray (1990), Goodhart (1991), Pollin (1991), Arestis and Howells (1996), Dalziel (1996), Palley (1996), and Dow (2007) on the structuralist position to the endogenous money theory.

2 See, for instance, Galbraith (1997), Wray (2001), Arestis, Caporale, and Cipollini (2002), Arestis and Sawyer (2004), Vernengo (2007), Perry and Cline (2016), Smithin (2017) on the post Keynesian critique on the orthodox theory of inflation.

3 Great Moderation (1982–2006) is, strictly speaking, only applicable until the early 2000 since there had been inflationary pressures looming since 2004 as shown in the Figure 1.

4 Setterfield (2013) claimed that consumption spending increased from the traditional level of 66% to 70% of U.S. GDP despite stagnating real wages in recent decades.

5 Ability and willingness of banks to lend is, in turn, affected by the liquidity preference of banks, rules of thumb established by financial institutions regarding appropriate leverage ratios, competition among financial institutions, innovations that generate new instruments or practices, central bank (potential) intervention, and expectations regarding future profitability and interest rates (Wray 1990). However, in this empirical approach, we do not distinguish between demand for credit and supply of credit.

6 The demand-pull inflation is generally considered as the domain of the orthodox theory of inflation, which is represented well in the statement, “too much money chasing after too few goods.” However, a post Keynesian view of demand-pull inflation is fundamentally different as it derives from endogenous money approach while the former perspective bases its theory on exogenous money theory.

7 Where p is the growth of the price level, k of the profit rate, w is of the wage, a is of the productivity growth, h0 > 0, and 0 < h1 < 1.

8 A proxy variable for household credit-drive spending is total household credit that mainly consists of consumer credit and mortgage credit as both can be used to finance consumption. Mortgage equity withdrawal, that is, the cash extracted from housing by borrowing in the mortgage market, could be used to purchase goods and services (Barba and Pivetti 2008). Mason (2018) found a significant increase in net funds flowing to households through mortgages and related forms of housing credit, which was potentially available to finance consumption for the housing boom period. And, mortgage credit for house purchase is also relevant to aggregate demand to the extent that it contributes to a new construction despite its minor portion of the total volume of mortgage loans. Therefore, the author believes the total household credit can be a better proxy for credit-driven household spending than household credit for consumption because the latter is most likely to underestimate the impact of household credit on their spending. Jayadev and Mason (2015), interestingly, claimed that increases in household debt-to-income ratios are mainly attributed to rises in nominal interest rates relative to nominal income growth since the early 1980s while they conceded household leverage/deleveraging pattern was directly associated with increased/decreased aggregate demand from 2000 to 2011. It is consistent with this paper in that households-credit-driven inflation is only valid in the 2000s not over the total sample period of the early 1980s to 2016, as will be shown later.

9 A reduced form VAR is better than a structural VAR in that it does not have to impose required identifying assumptions. Instead of reasoning out conclusions from premises assumed to be true, such a methodology allows data to determine the actual empirical relationships. However, it cannot capture the contemporaneous causation.

10 There are also quarters after 2000Q3 verified as break points and as such, it can be interpreted that a gradual structural change had occurred over a long period. The Chow break test results are available from the author upon request.

11 See Supplementary Appendix B for the unit root test results.

12 Engle and Granger (1987), Phillips and Ouliaris (1990) cointegration testing indicates there is no long-run relationship between the variables over the total sample (1983Q2–2016Q1) and a sub-sample (2000Q3–2016Q1). The Johansen test (1991, 1995) indicates at least one cointegrating equation but the long-run causal relationship is not verified in a vector error correction model.

13 When oil price is used instead of import price index, the estimation results are not different.

14 The Phillips curve claims that there is an empirical tradeoff between inflation and unemployment level and that there is a level of natural unemployment at which prices are stable.

15 The Monetarist, simply put, argues that growing reserves would lead to higher inflation through increasing credit creation according to Quantitative theory of money. They are wrong in that reserves are the beginning when the causation is actually reversed from M1 or M2 to reserves.

Additional information

Notes on contributors

Hongkil Kim

Hongkil Kim is an assistant professor in the Department of Economics at the University of North Carolina at Asheville.