Inflation and Wicksell, by Leijonhufvud

The Federal Reserve does not have a working theory of inflation. That is a big deal because price stability is half its mandate.

The Phillips curve relationship -- a negative correlation between unemployment and inflation, identified by A.W. Phillips in data for the UK between 1861 and 1957 -- has been weak. Possible reasons include (i) people expect lower inflation and it's a self-fulfilling prophesy, (ii) labor unions are weaker so wage gains are weaker so corporate costs increase more slowly, (iii) the rise of e-commerce has created more competition between retailers, and (iv) shifting factories to lower-cost producers like China has kept costs down. Any/all of these factors might be keeping inflation down.

For a large part of the past 40 years, policymakers operated from a Quantity Theory of money view, summarized by Milton Friedman's "inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output." This sounds legitimate but was always a bit dubious. It became openly indefensible after the huge increase in the money supply after 2008 did not result in inflation. Since the mid 1990s inflation has almost always been lower than the increase in M2. But knowing that the Quantity Theory is not right does not answer the question of what actually causes inflation.

Axel Leijonhufvud (1997) points out that Knut Wicksell made some good points on this in 1898 (as well as on "the hypothesis of intertemporal disequilibrium as the key to the understanding of business cycles"), which many economists have ignored to the detriment of macroeconomics and monetary theory as we understand it today.

http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.404.5867&rep=rep1&type=pdf.

Here are three questions Leijonhfvud's article helps to answer 

1. Why is the Quantity Theory suspect?

David Ricardo's quantity theory of the price level is "completely sound and correct" for a pure "cash economy". We live however in a mostly credit economy.

"Bank money was credit money and, unlike metallic money, could not be in excess supply, Tooke maintained. An overissue by the banks would simply produce a "reflux" of notes in repayment of loans. If expansions and contractions of the banks drove the price level, rising prices should be associated with low interest rates and vice versa. But the evidence ... was just the opposite."  

2. Why not just adopt the alternative theory?

Thomas Tooke's anti-quantity theoretical conclusion is that the price level determines the stock of money. This may be true, "but it left one with no tenable theory of the price level at all."

Wicksell concluded that "the Quantity Theory cannot just be thrown overboard ... The Quantity Theory was the only monetary theory with any claim to scientific status. But it left out the influence on the price level of credit-financed demand." This omission becomes major when bank credit reduces the role of metallic money in the economy. 

"Wicksell presented a pure credit system model as "a precise antithesis to the equally imaginary case of a pure cash system, in which credit plays no part whatever ... The strategy for developing applied monetary theory, he suggested, was to regard actual monetary systems

"as combinations of these two extreme types. If we can obtain a clear picture of the causes responsible for the value of money in both of these imaginary cases, we shall, I think, have found the right key to a solution of the complications which monetary phenomena exhibit in practice."

3. What's the right combination?

There's the rub.

Wicksell's suggestion "is a stroke of genius ... But it is by the same token deeply problematic, for Wicksell has very little to tell us about how to go about fashioning a viable synthesis from his two antithetical models."

"This lack of an outline of the suggested synthesis has been unfortunate in that the Ricardian thesis and Tookean antithesis have been carried down to the present day as mutually exclusive theories with Monetarists denying the relevance of credit and Credit theorists still lacking a theory of the price level. Thus Milton Friedman turned the evolutionary argument against Credit theories: monetary theory should focus on the banking system's liabilities and not on their assets which evolution had reduced to a minor component of total credit. More recently, monetary general equilibrium theorists have generally been content simply to brush credit under the Modigliani-Miller rug. On the other side, the Tookean tradition has its most persuasive advocate today in Basil Moore."

The instability that Wicksell foresaw was postponed when in the early 20th century governments monopolized note issue and imposed reserve requirements on banks, which "gave the Quantity Theory a new lease of life." In recent decades, however, the expanded use of "smart cards" (credit cards) and the elimination of reserve requirements (which happened officially on March 15, 2020, but effectively years ago) have probably all but ended any stable relationship between aggregate demand and the "vanishingly small" monetary base.

"The newest generation of jet fighter planes ... are inherently unstable in the air and depend on extremely fast feedback-based electronic control (In fact, they cannot be flown by human pilots).

"Price level stabilization by Wicksellian bank rate policy may become similarly challenging before very long. Perhaps it is fortunate that we will be able to entrust it to a Nintendo-trained generation."

The world keeps changing and monetary policymakers need to keep adapting. 

Final note: this article is worth (re) reading, it's short and there's much in that I don't cover here.