M.A. FINAL ECON: Gordon's Triangle

From M.A. FINAL ECONOMICS by Sehba Hussain and edited by Professor Shakoor Khan:

2.6.3 Gordon's triangle model
Robert J. Gordon of Northwestern University has analysed the Phillips curve to produce what he calls the triangle model, in which the actual inflation rate is determined by the sum of
1. demand pull or short-term Phillips curve inflation,
2. cost push or supply shocks, and
3. built-in inflation.
The last reflects inflationary expectations and the price/wage spiral.

(That's word-for-word the same as the haicuan blog Notes.)

Caught my eye because they say inflation is "the sum of" the three components. Leads me to think that if I was smart enough I could calculate inflation from money growth and stuff like that. And maybe that Robert Gordon has already figured out the calculation, so I don't have to be that smart.

I have to point out that economists brusquely dismiss the concept of cost-push inflation, but are highly focused on "supply shocks" as an explanation of almost everything. You know: oil as a supply shock, causing inflation in the 1970s. But tsk-tsk, don't call it "cost-push" inflation.

And yet item 2 in the triangle model description above says "cost push or supply shocks" as if these are two different names for the same phenomenon! (Note that in item 1, "demand pull" and "short-term Phillips curve inflation" are clearly offered as two different names for the same phenomenon.)

There's more on Gordon's Triangle elsewhere in the FINAL ECON paper:

2.3 KEYNESIAN VIEW
Keynesian economic theory proposes that changes in money supply do not directly affect prices, and that visible inflation is the result of pressures in the economy expressing themselves in prices. The supply of money is a major, but not the only, cause of inflation.

There are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model":
Demand-pull inflation is caused by increases in aggregate demand due to increased private and government spending, etc. Demand inflation is constructive to a faster rate of economic growth since the excess demand and favourable market conditions will stimulate investment and expansion.

Cost-push inflation, also called "supply shock inflation," is caused by a drop in aggregate supply (potential output). This may be due to natural disasters, or increased prices of inputs. For example, a sudden decrease in the supply of oil, leading to increased oil prices, can cause cost-push inflation. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices.

Built-in inflation is induced by adaptive expectations, and is often linked to the "price/wage spiral". It involves workers trying to keep their wages up with prices (above the rate of inflation), and firms passing these higher labor costs on to their customers as higher prices, leading to a 'vicious circle'. Built-in inflation reflects events in the past, and so might be seen as hangover inflation.

Demand-pull theory states that the rate of inflation accelerates whenever aggregate demand is increased beyond the ability of the economy to produce (its potential output). Hence, any factor that increases aggregate demand can cause inflation. However, in the long run, aggregate demand can be held above productive capacity only by increasing the quantity of money in circulation faster than the real growth rate of the economy. Another (although much less common) cause can be a rapid decline in the demand for money, as happened in Europe during the Black Death...

(That's not quite word-for-word from Wikipedia.)


At IDEAS: A Consistent Characterization of a Near-Century of Price Behavior, by Robert J. Gordon, 1980. From the abstract:

This paper develops a single econometric equation that can explain most of the variation in the aggregate U.S. rate of inflation during the period between 1892·and 1978.

No shit. And this:

The formation of price expectations changed completely after 1950 from regressive expectations appropriate under a gold standard to extrapolative inertia-dominated expectations appropriate under a fiat money standard and postwar long-period wage contracts.

Interesting, and it sounds right. It has occurred to me that when prices were tied to gold, there wasn't much that could be done to boost the quantity of money. But when money's connection to gold became tenuous, it became possible to increase the Q of M. So I think we should expect to see the thing that Robert Gordon points out here.

Related, from the text:

The EPC [Expectational Phillips Curve] explanation, which in its most general form relates price change to expected inflation and the level of detrended output, obscures the fact that price change has been much more closely related to the contemporaneous rate of change of detrended output.

And:

... while the formation of inflation expectations has shifted in the postwar years,
the cyclical impact of detrended output changes has not.

And on page 4:

... under a gold standard we might find the price level jumping up and down around a stable or slowly moving trend ... But under the postwar fiat-money standard, few increases in the price level have been reversed.

//

Here's a place to start:

Over the near-century of annual data studied here, a change in output has shown a remarkably consistent tendency to be associated in annual data with a simultaneous change in the price level of about one-half as much. Stated another way, nominal GNP changes have been divided consistently, with two-thirds taking the form of output change and the remaining one-third the form of price change.

If true, that's a pretty interesting rule of thumb; could be as useful as Okun's law. But I've heard of Okun's and I haven't heard of Gordon's law, so maybe Gordon's law didn't hold up. I guess I'll take a look at the data.

Yeah, but not today.

M.A. FINAL ECON: "the whole 800 years leading up to 1820"

From section 2.4: HISTORY OF BALANCE OF PAYMENTS ISSUES in M.A. FINAL ECONOMICS by Sehba Hussain, edited by Professor Shakoor Khan:

From about the 16th century, Mercantilism was a prevalent theory influencing European rulers, who sometimes strove to have their countries out-sell competitors and so build up a "war chest" of gold. This era saw low levels of economic growth; average global per capita income is not considered to have significantly risen in the whole 800 years leading up to 1820, and is estimated to have increased on average by less than 0.1% per year between 1700-1820.

First impression: I like that last sentence, so rich with stats.

Second thought: I wonder if this is original writing, or borrowed.

Borrowed.

M.A. FINAL ECONOMICS at studyres.com

In the If by deliberate policy search I did the other day, something that looked interesting turned up: M.A. FINAL ECONOMICS at studyres.com.

I poked around a little, finding enough that I wanted to come back for a more thorough look.

I found something on Robert J. Gordon and his "triangle model" of inflation. I heard of that 20 years ago or more, and had in the back of my mind ever since. Never went looking for it, but now here it was, quite by accident. So I made a note and kept the link to the M.A. FINAL ECONOMICS page handy, planning to get to it -- some time in the next 20 years maybe.

Then I came across the names Samuelson and Solow, together like that: a reference to their 1960 article that I've been on about lately. So I added to my note:

I DON'T KNOW WHAT THIS [PAGE] IS BUT IT MIGHT BE INTERESTING

While I was there I read the first sentence of the S&S part:

2.7 SAMUELSON AND SOLOW’S APPROACH
As this model says, it is not possible on the basis of a priori reasoning to reject either the demand-pull or cost-push hypothesis, or the variants of the latter such as demand-shift...

Ah, the good stuff. It struck me as a paraphrase, at first. But I remembered the words "a priori reasoning" and I remember S&S not rejecting "either the demand-pull or cost-push hypothesis, or the variants". Seemed like a lot of identical words, for one sentence. Sort of a relaxed paraphrase, or maybe a plagiaphrase. Couldn't say for sure, but I had to go back to my "I don't know what this is" note and double-underline it.

That was two or three days ago. I'm back to it now to see what I saw. I compared the M.A. FINAL ECON article to the Samuelson and Solow article that I recently extracted from the Joint Economic Committee report and put on the blog. The two are not identical after all. I've taken a few paragraphs of each, and highlighted the differences; I made the paragraph breaks the same for both, to make reading and comparison easier. The original paper from 1960 on the left; the M.A. FINAL ECON paper on the right:

IV

2.7 SAMUELSON AND SOLOW’S APPROACH

We have concluded that it is not possible on the basis of a priori reasoning to reject either the demand-pull or cost-push hypothesis, or the variants of the latter such as demand-shift. We have also argued that the empirical identifications needed to distinguish between these hypotheses may be quite impossible from the experience of macrodata that is available to us; and that, while use of microdata might throw additional light on the problem, even here identification is fraught with difficulties and ambiguities. Nevertheless, there is one area where policy interest and the desire for scientific understanding for its own sake come together. If by deliberate policy one engineered a sizable reduction of demand or refused to permit the increase in demand that would be needed to preserve high employment, one would have an experiment that could hope to distinguish between the validity of the demand-pull and the cost-push theory as we would operationally reformulate those theories. If a small relaxation of demand were followed by great moderations in the march of wages and other costs so that the social cost of a stable price index turned out to be very small in terms of sacrificed high-level employment and output, then the demand-pull hypothesis would have received its most important confirmation. On the other hand, if mild demand repression checked cost and price increases not at all or only mildly, so that considerable unemployment would have to be engineered before the price-level updrift could be prevented, then the cost-push hypothesis would have received its most important confirmation. If the outcome of this experience turned out to be in between these extreme cases-as we ourselves would rather expect-then an element of validity would have to be conceded to both views; and dull as it is to have to embrace eclectic theories, scholars who wished to be realistic would have to steel themselves to doing so. Of course, we have been talking glibly of a vast experiment. Actually such an operation would be fraught with implications for social welfare. Naturally, since they are confident that it would be a success,the believers in demand-pull ought to welcome such an experiment. But, equally naturally, the believers in cost-push would be dead set against such an engineered low-pressure economy, since they are equally convinced that it will be a dismal failure involving much needless social pain...

As this model says, it is not possible on the basis of a priori reasoning to reject either the demand-pull or cost-push hypothesis, or the variants of the latter such as demand-shift. UTe have also argued that the empirical identifications needed to distinguish between these hypotheses may be quite impossible from the experience of macro data that is available to us; and that, while use of microdot might throw additional light on the problem; even here identification is fraught with difficulties and ambiguities. Nevertheless, there is one area where policy interest and the desire for scientific understanding for its own sake come together. If by deliberate policy one engineered a sizable reduction of demand or refused to permit the increase in demand that would be needed to preserve high employment, one would have an experiment that could hope to distinguish between the validity of the demand-pull and the cost-push theory as we would operationally reformulate those theories. If a small relaxation of demand were followed by great moderations in the march of wages and other costs so that the social cost of a stable price index turned out to be very small in terms of sacrificed high-level employment and output, then the demand-pull hypothesis would have received its most important confirmation. On the other hand, if mild demand repression checked cost and price increases not at all or only mildly, so that considerable unemployment would have to be engineered before the price level up drift could be prevented, then the cost-push hypothesis would have received its most important confirmation. If the outcome of this experience turned out to be in between these extreme cases-as we ourselves would rather expect-then an element of validity would have to be conceded to both views; and dull as it is to have to embrace eclectic theories, scholars who wished to be realistic would have to steel themselves to doing so. Of course, we have been talking glibly of a vast experiment. Actually such an operation would be fraught with implications for in demand-pull ought to welcome such an experiment. But, equally naturally, the believers in cost-push would be dead set against such an engineered low-pressure economy, since they are equally convinced that it will be a dismal failure involving much needless social pain...

Okay. To tie this all together I want to point out that Samuelson and Solow said "it is not possible on the basis of a priori reasoning to reject either the demand-pull or cost-push hypothesis". And the M.A. FINAL ECON paper says it. And I say it, and maybe you also, I dunno. But Paul Volcker most definitely did not say it.

Gone was the notion of cost-push versus demand-pull. Volcker implicitly accepted that rising inflation was caused by “demand-pull”.

A Key Quote from Samuelson and Solow (1960)

The full thought, from section IV of Samuelson and Solow (1960):

"If by deliberate policy one engineered a sizable reduction of demand or refused to permit the increase in demand that would be needed to preserve high employment, one would have an experiment that could hope to distinguish between the validity of the demand-pull and the cost-push theory as we would operationally reformulate those theories."

I have to go back and check what they mean by "as we would operationally reformulate those theories", but Paul Volcker performed that experiment as Chairman of the Federal Reserve. Marcus Nunes writes:

On becoming chairman of the Fed, Volker challenged the Keynesian orthodoxy which held that the high unemployment high inflation combination of the 1970´s demonstrated that inflation arose from cost-push and supply shocks – a situation dubbed “stagflation”...

To Volker, the policy adopted by the FOMC “rests on a simple premise, documented by centuries of experience, that the inflation process is ultimately related to excessive growth in money and credit”.

This view, an overhaul of Fed doctrine, implicitly accepts that rising inflation is caused by “demand-pull” or excess aggregate demand or nominal spending.

Josh Hendrickson concurs:

... Relying on public statements and personal diary entries from Arthur Burns, I demonstrate that there is little evidence that the Federal Reserve was less concerned with inflation during the 1970s. Rather, the view of Burns and others was that inflation was largely a cost-push phenomenon. Burns thought that incomes policies were necessary to restore price stability and stated that “monetary and fiscal tools are inadequate for dealing with sources of price inflation that are plaguing us now.”

The shift in policy, beginning with Paul Volcker, was an explicit attempt to stabilize inflation expectations and this was done deliberately at first through monetary targeting and ultimately through the stabilization of nominal income growth. Gone were notions of cost-push versus demand-pull inflation. The Fed simply assumed accountability as the creator of inflation.

The Fed limited the growth of the quantity of money and limited the growth of nominal income. Volcker ran the experiment. Gone was the notion of cost-push versus demand-pull. Volcker implicitly accepted that rising inflation was caused by “demand-pull”.

Even before the experiment was over, cost-push was no longer considered valid theory. That was Volcker's premise. Today, the cost-push idea is taken as some kind of joke -- or quaint, perhaps, but definitely wrong. In comments on Hendrickson's post, Nick Rowe quoted the part about Burns thinking inflation was largely a cost-push phenomenon. and replied:

People forget (and maybe younger people never knew) just how common that view was in the 1970’s. It was common among economists as well as the general population. It was almost the orthodoxy of the time, IIRC. Tighter monetary policy would just raise interest rates, which would increase costs, and make inflation even worse.

Hendrickson agreed with Rowe. Nunes agreed with Hendrickson's post. And Bill Woolsey wrote:

There were really _economists_ who thought that “tighter money” would raise inflation through a cost-push mechanism?

I got in on the action and responded with a yup to Woolsey, quoting Robert V. Roosa, past vice president of the New York Fed, and Undersecretary for Monetary Affairs under President John F. Kennedy. Roosa, from Fortune magazine, September 1971:

And yet another factor has been the undue reliance on restrictive monetary policy to limit demand, with the perverse result of making interest rates themselves a major cost-push force.

Roosa's kind of thinking has been almost universally dismissed by economists. That dismissal is a case where the old ideas ramify into every corner of our minds.

In the US, in 1952, interest costs amounted to 5.67% of GDP, a pretty low number. Sixty years later in 2012, interest costs came to 15.42% of GDP. That's a difference of almost ten percent of GDP. If our reliance on credit hadn't increased, and our interest costs still amounted to 5.67% of GDP, prices could have been almost 10% lower than they actually were in 2012 -- with the difference not involving wages, but only interest costs.

Oh by the way: in 1952 the effective interest rate in the US was 4.35%. In 2012 that rate was 4.36%. Almost identical. (That's why I picked the years 1952 and 2012.) The interest rate was the same, but the interest cost was $160 billion more in 2012 than 1952. Why? Because there was more debt in 2012. A lot more debt.

Paul Volcker on the tradeoff

From The Federal Reserve’s “Dual Mandate”: The Evolution of an Idea (PDF):

Volcker defended the Fed’s actions in 1981 testimony to the Senate Committee on Banking, Housing, and Urban Affairs:

I am wholly convinced—and I think I can speak for the whole Board and whole Open Market Committee—that recognizing that that objective for unemployment [4 percent] cannot be reached in the short run—the kinds of policies we are following offer the best prospect of returning the economy in time to a course where we can combine as full employment as we can get with price stability.

I bring in price stability because we will not be successful, in my opinion, in pursuing a full employment policy unless we take care of the inflation side of the equation while we are doing it. I think that philosophy is actually embodied in the Humphrey-Hawkins Act itself. I don’t think that we have the choice in current circumstances—the old tradeoff analysis—of buying full employment with a little more inflation.

We found out that doesn’t work, and we are in an economic situation in which we can’t achieve either of those objectives immediately. We have to work toward both of them; we have to deal with inflation. And the Federal Reserve has particular responsibilities in that connection.

The Volcker Experiment

From A Dynamic Factor Model of the Yield Curve as a Predictor of the Economy at the website of the Federal Reserve Board:

In October 1979, the Federal Reserve Bank adopted new operating procedures shifting their emphasis from targeting the federal funds rate to the quantity of non-borrowed bank reserves in order to achieve the desired rates of growth in the monetary aggregates.

Before October 1979 they focused on the Federal Funds Rate. In October 1979, under Volcker, they switched to a focus on "the quantity of non-borrowed bank reserves". They switched, that is, to a focus on the quantity of money.

From Understanding Open Market Operations (PDF) by M. A. Akhtar, at the St. Louis Fed:

The formulation of monetary policy has undergone significant shifts over the years. In the early 1980s, for example, the Federal Reserve placed special emphasis on objectives for the monetary aggregates as policy guides for indicating the state of the economy and for stabilizing the price level. Since that time, however, ongoing and far-reaching changes in the financial system have reduced the usefulness of the monetary aggregates as policy guides.

"Monetary aggregates" is a reference to various measures of the quantity of money. Akhtar says that changes in the financial system reduced the usefulness of the quantity of money as a policy tool.

Changes in the financial system? What changes? The expansion of credit, obviously. Oh, a million other things, of course, but in brief the end result was the expansion of credit.


Not sure of the timing of the Fed's shift away from monetary aggregates. Wikipedia says

in 1984 the Federal Reserve officially discarded monetarism

Oh -- that's footnoted to the Huffington Post which, in my experience, is not a reliable source. Here's Krugman and Wells from page 896 from their Economics text at Google Books:

In the late 1970s and early 1980s the Federal Reserve flirted with monetarism. For most of its prior existence, the Fed had targeted interest rates, adjusting its target based on the state of the economy. In the late 1970s, however, the Fed adopted a monetary policy rule and began announcing target ranges for several measures of the money supply. It also stopped setting targets for interest rates. Most people interpreted these changes as a strong move toward monetarism.

In 1982, however, the Fed turned its back on monetarism. Since 1982 the Fed has pursued a discretionary monetary policy, which has led to large swings in the money supply. At the end of the 1980s, the Fed returned to conducting monetary policy by setting target levels for the interest rate.

Other sources reference a somewhat later end-date. For example, this from What Was Behind the M2 Breakdown? at the New York Fed:

A deterioration in the link between the M2 monetary aggregate and GDP, along with large errors in predicting M2 growth, led the Board of Governors to downgrade the M2 aggregate as a reliable indicator of monetary policy in 1993.

And finally, while looking up the above history I found Friedman's change-of-heart statement at Wikiquote, referenced to the Financial Times of 7 June 2003:

The use of quantity of money as a target has not been a success. I'm not sure that I would as of today push it as hard as I once did.

"Oops."

Household Debt Service by Vintage since 1999

"Looks like they do some significant revising of the debt service data. Maybe I'll do a post on that. Maybe I will." -- me

It was easy. Went to FRED TDSP and took the link to ALFRED. They have "vintages" of the debt service data beginning in 1999, with a new one every three months or so, up to the present. I put the first 10 of em into a graph, then figured I'd better save it. So I clicked DOWNLOAD. The first option ALFRED offers is "All Vintages (data)". Whoa, exactly what I wanted. Got it as an Excel file. Didn't need to do em 10 at a time.

I didn't know how many lines I could plot in one graph in Excel. Tried columns A to Z, and it worked. So then I tried em all, column A to column CD. And it worked.

I wrote a little VBA routine to make all the lines thin and black; the heart of it is here:

Dim s As Object: For Each s In ActiveChart.SeriesCollection
    s.Select
    With Selection.Border
      On Error Resume Next
        .ColorIndex = BLACKLIN
      On Error GoTo 0
        .Weight = xlThin
        .LineStyle = xlContinuous
    End With
  Next s

Your basic For/Next loop.

I didn't identify which line is which on the graph, but you can more or less tell by where each one ends. Anyway, the point of the graph is just to show there is substantial revision in the Household Debt Service data. The first line, high on the graph, is the November 9, 1999 vintage. I made that one red. Also red, low on the graph, is the most recent vintage: September 25, 2019. Getting late in the year, isn't it. November already.

Also red: The last vintage before the big change: June 19, 2003; and the first vintage after that change: October 22, 2003. Notes related to that revision appear in the PDF "Recent Changes to a Measure of U.S. Household Debt Service" by Karen Dynan, Kathleen Johnson, and Karen Pence.

Here's the graph as FRED shows it:

Graph #1

Here's what the ALFRED data gave me:

Graph #2

You can click the second graph for an enlarged view.