PRICE INDICES, MONETARY ANALYSIS, AND INFLATION A MACRO-THEORETICAL INVESTIGATION Sergio Rossi University College London Department of Economics Ph.D. Thesis 2000 ProQuest Number: U643111 All rights reserved INFORMATION TO ALL USERS The quality of this reproduction is dependent upon the quality of the copy submitted. In the unlikely event that the author did not send a complete manuscript and there are missing pages, these will be noted. Also, if material had to be removed, a note will indicate the deletion. uest. ProQuest U643111 Published by ProQuest LLC(2015). Copyright of the Dissertation is held by the Author. All rights reserved. This work is protected against unauthorized copying under Title 17, United States Code. Microform Edition © ProQuest LLC. ProQuest LLC 789 East Eisenhower Parkway P.O. Box 1346 Ann Arbor, Ml 48106-1346 ABSTRACT This thesis investigates inflation from a macro-theoretical point of view. It originates in a critical appraisal of traditional inflation analysis, where the latter phenomenon is identified with an ongoing increase in the level of aggregate prices because ‘too much money is chasing too few goods’. It argues that the prevalent idea of money and output being two separate and autonomous objects can neither explain the value of money nor its variations over time. It also argues that output as a whole cannot be measured in this widely-shared analytical framework. A new theory is called for. The problem of inflation in the alternative framework developed in the thesis reveals its essentially macroeconomic nature. It is argued that to gain an understanding of inflation it is necessary to focus analysis on the formation of national income and not on its distribution. Within the proposed new framework, the production process is investigated in terms of flows, rather than in terms of stocks changing hands in the process of output circulation; both money and banking are instrumental in generating, and measuring, macroeconomic magnitudes. Elaboration of the role of money and banking in this analytical framework provides a number of theoretical propositions that lead to the conclusion that the origin of inflation is ‘monetary’ and ‘structural’ rather than ‘real’ and ‘behavioural’. The monetary-structural element is the design of the payment system; when this system is redesigned to recognise the macroeconomic relationship existing between bank money and production, inflationary pressures are at least revealed and may be eliminated. This thesis seeks to contribute to such a conceptual design. CONTENTS ABSTRACT 2 CONTENTS 3 TABLES 6 FIGURES 7 ACKNOWLEDGEMENTS 8 INTRODUCTION 9 Part I Methodological issues in the measurement of inflation 1 THE METHODOLOGICAL DEBATE IN TRADITIONAL ANALYSIS 20 Some notes on the conventional measures of inflation 20 Defining inflation 20 Introducing price index analysis 25 Selecting the appropriate formula 29 Debated methodological issues in traditional analysis 35 The compositional issue of the representative market basket 39 From consumer price indices to cost-of-living indices 47 2 FROM TECHNICAL BIASES TO ANALYTICAL ISSUES 54 Measurement problems in aggregate price indices 54 The substitution bias 56 The new-goods bias 59 The quality-change bias 62 Analytical causes of inflation measurement problems 71 The representative market basket and total current supply 71 The sample of population and total current demand 77 The problem of aggregating microeconomic data 80 Part n Towards a macroeconomic analysis of inflationary disequilibria 3 THE NEOCLASSICAL ANALYSIS OF INFLATION: A CRITICAL APPRAISAL 91 The optimum quantity of money and other issues 94 The Fisherine quantity equation 94 The Cambridge quantity equation 101 The modern quantity equation and the expected inflation rate 104 The dichotomous representation of monetary economies 110 Money and output as two distinct objects 112 Money, a veil? 115 Homogeneity postulate and inflation 119 4 THE ARGUMENT REFINED: EXOGENOUS AND ENDOGENOUS MONEY 123 Exogenous money, or the dichotomy revisited 124 The medium of exchange, a monetary asset? 126 The Cartalist idea of outside money and the inflation tax 135 Endogenous money, or the association of money and output 146 Money, a numérairel 146 The means of payment, a double-entry integer 150 Part III A modern paradigm for inflation analysis 5 WAGE SETTING, CREDIT POLICY, AND INFLATION 160 The macroeconomics of the wage bargain 161 Labour productivity, effective demand, and money wages 161 The conflict inflation approach: a critical appraisal 177 Bank credit and inflation 187 Excess credit facilities and inflation: a reconsideration 188 Inflation: is there any macroeconomic harm? 198 6 INFLATION AND CAPITAL ACCUMULATION 209 Empty money and inflation 211 Empty money, forced saving, and fixed capital 212 The amortisation of fixed capital 216 An outline of structural monetary reform 222 On the book-entry distinction between money and credit 223 On the necessary introduction of a fixed capital department 234 7 MAIN CONCLUSIONS AND PERSPECTIVES FOR FURTHER INQUIRY 244 Aim of the thesis and methodology chosen 244 A methodological and heuristic assessment of our analysis 244 Criticisms raised in the interpretation of Schmitt's theory 258 Some perspectives for further research 264 Epilogue 267 BIBLIOGRAPHY 269 TABLES Table 1.1 A typology of inflationary phenomena 23 Table 1.2 Frequency of weighting revisions of some official price indices 36 Table 4.1 The inflation tax: real goods vs. nominal money 140 Table 4.2 The financing of public sector deficits 145 Table 4.3 The result of an absolute exchange on the factor market 152 Table 5.1 A speculation-led excess of bank credit 190 Table 5.2 The macroeconomic result of excess credit facilities 192 Table 6.1 The bi partition of the banks' bookkeeping 225 Table 6.2 Savings, the financial market, and the two departments 228 Table 6.3 The working of the fixed capital department 238 FIGURES Figure 1.1 The concept of price level 24 Figure 2.1 The macroeconomic inadequacy of the representative basket 74 Figure 2.2 Total demand and representative demand 79 Figure 3.1 The concept of relative exchange 95 Figure 4.1 The medium-of-exchange function of ‘monetary assets’ 126 Figure 4.2 The sale of national output in neoclassical analysis 132 Figure 4.3 The exchange of fiat money for goods and services 141 Figure 4.4 The two absolute exchanges of national output 155 Figure 5.1 Inclusion of a positive expenditure into a negative expenditure 204 ACKNOWLEDGEMENTS It is the author's pleasure to acknowledge his intellectual debt to a number of people who have contributed to the development of this work in several important ways. In this regard, I would like to thank wholeheartedly my two Supervisors: Professors Victoria Chick and Lord Desai. Though they would not agree entirely with the conceptual framework that shapes the diagnosis developed in this thesis, their constant support and critical contribution have been an invaluable help in the completion of this research. Without implicating them for any remaining error or opinions expressed here, they should also be warmly thanked for the privilege they granted to me to work so closely with them and thus to benefit from their world-known expertise. I am also most grateful to Professors Heinrich Bortis, Alvaro Cencini, Bernard Dafflon, and Bernard Schmitt for their advice, encouragement and constructive criticism over the whole period I have spent in the UK since my first post-doctoral research year at the London School of Economics. I would also like to thank many people and institutions for the provision of scientific work that would have been otherwise impossible to obtain; in particular, the Bank of England, the Deutsche Bundesbank, the European Central Bank, and the Swiss Federal Statistical Office (especially Doctors Lorenzo Cascioni and Marcello Corti). Simona Cain made an important contribution in improving the style of Chapters 1 to 4. I am indebted to her as well as to the Swiss National Science Foundation, the Divisione della cultura del Cantone Ticino, the Fondazione Arturo & Marguerite Lang, and the Fondazione Felix Leemann for their financial support. Although the author is the sole responsible for the result, this work has also been possible thanks to an Overseas Research Students Award by the Committee of Vice-Chancellors and Principals of the United Kingdom, which is gratefully acknowledged. At a more personal level, I am most grateful to my mother for her constant, and multifaceted, support, especially when stress and discouragement have put the completion of this research at risk. This thesis is dedicated to her. INTRODUCTION This thesis aims at three goals. The first is to discuss the methodological issues involved in the measurement of inflation, as established by reference to index number theory and its specific application, that is, the retail (or consumer) price index. As the influential Chairman of the Board of Governors of the US Federal Reserve System has recently observed, ‘[t]he remarkable progress that has been made by virtually all of the major industrial countries in achieving low rates of inflation in recent years has brought into sharper focus the issue of price measurement’ (Greenspan 1997b: 1). Granting this progress, a new set of issues is now emerging on the agenda of economic policy makers. ‘As we move closer to price stability, the necessity of measuring prices accurately has become an especial challenge. Biases of a few tenths in annual inflation rates do not matter when inflation is high. They do matter when, as now, a debate has emerged over whether our economies are moving toward price deflation’ (p. 1). Accurately measuring prices and the rate of change of aggregate price levels is indeed of central importance for current investigation into our market-based monetary economies of production. It is in particular necessary for analysing economic developments, including output growth, government spending, and poverty rates, as well as for conducting macroeconomic policy.