Modern Monetary Theory (MMT) versus Orthodox Economists on Inflation — Who’s Right?
A plain language introduction to understanding inflation. Comparing mainstream and MMT approaches.
As my imaginary MMT critic never tires of saying, ’MMTers are mad, they think they can just spend, spend, spend and everything will be fine. Have these idiots never heard of inflation?’ Hmm, my imaginary critic has great insight. Well, I’m here to say, this particular MMT idiot has heard of inflation and, contrary to common criticisms, this idiot also knows that inflation is actually at the heart of all MMT thinking about the economy.
In this article I will demonstrate that this is the case by exploring the topic of inflation from an MMT perspective. We will learn what inflation is, what causes it, and how orthodox and MMT economists attempt to deal with it. Let’s start with a simple question. Inflation, what is it?
Inflation - What is it?
Inflation means a continuous increase in prices, not a one-off increase. For example, a rise in the price of stamps may well push prices up, but that one-time price increase for sending a letter is not inflation. On the other hand, if energy costs keep rising over time, and given that energy is such an integral part of economic activity, that means prices are also likely to keep rising over time. That’s inflation.
This is an important point to grasp. If a politician says we can’t have an increase in the minimum wage rate because it will cause inflation - you can question their logic.
A one-off increase may well put up prices but it doesn’t necessarily follow that it will lead to ongoing price increases. There are of course many variables at play in the economy so we can’t say for sure. But we are in a better position to understand the likely outcome of any particular policy if we remember that inflation is an ‘ongoing change over time’ and not a one off increase in prices.
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Who measures inflation?
In the UK, inflation is measured by indices like the Consumer Price Index (CPI) or Producer Price Index (PPI). The CPI measures the average change over time in the prices paid by consumers for a basket of goods and services. This is published by the Office for National Statistics (ONS).
The ‘basket’ of goods and and services is made up of hundreds of the most commonly purchased items and is designed to reflect the spending habits of UK households. The makeup of the basket gets changed as spending habits change.
Inflation and the Bank of England (BoE)
It is the CPI that the Bank of England is referring to when it publishes inflation targets. So inflation doesn’t mean all prices are rising, it means that, on average, the overall price level is going up over time.
Note, that the US carries out the same ‘basket of goods and services’ exercise as the UK and their official price index has the same name, the Consumer Price Index (CPI). In the US it is compiled and published by the U.S. Bureau of Labor Statistics (BLS).
Inflation and the cost of living
Inflation does not necessarily mean that the ‘cost of living’ goes up as prices go up. That depends on whether wages and/or interest earned on savings are also going up - or not. If income goes up slower - clearly, each pound spent buys less and less over time. On the other hand if wages are rising faster than inflation citizens are becoming better off – despite the inflation.
The Causes of inflation
There are five main causes of inflation:
Demand-side inflation – This is when the demand for goods outstrips the ability of the economy to supply them. Or to put it another way – too much spending chasing too few goods and services - and that drives up prices.
Supply-side inflation – Also called cost-push inflation. This relates to rising input costs such as energy and raw materials.
Currency depreciation – For countries that have to purchase imports in a foreign currency, imports become more expensive when the same amount of domestic currency buys less foreign currency. (Over 70% of UK imports were invoiced in foreign currencies, mainly US dollars and euros – source: UK Government.) For countries like the US, which purchase imports in their own currency, currency depreciation has less of an impact on domestic inflation.
Geopolitical shocks – The effects of war, pandemics, or international oil price rises can drive up domestic prices.
Monopoly pricing power – Companies with little or no competition are able to raise prices.
I don’t intend to explore each of these causes of inflation in detail. Rather, my aim is to give you some context for my discussion of the different approaches that orthodox and MMT economists take to tackling the problems caused by inflation.
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Who decides on the policies used to address inflation? And who decides the inflation target?
Addressing the different causes of inflation - and ensuring it does not ‘run away with itself’ - is what anti-inflation policies are (or should be) designed to do. Both the UK, and the US governments, have an inflation target of 2%, which they regard as the optimal amount of inflation to ‘support price stability and economic growth’. It is then the job of the central bank to meet that target: using whatever tools they think are appropriate. Or, given what I’m about to say in this article, perhaps I should say tool — singular.
Monetary policy versus fiscal policy
To reach this target the government has two general approaches: monetary policy (lowering and increasing interest rates) and fiscal policy (spending and taxation). Monetary policy is carried out by the central bank. Fiscal policy is decided upon and approved by the elected government, in the UK via the Chancellor of the Exchequer. Fiscal policy is implemented by the Treasury, though the actual mechanics of spending and collecting taxes are carried out by the central bank.
Different assumptions lead to different diagnoses and treatment: orthodox and MMT approaches to inflation
Orthodox approaches to dealing with inflation lean towards assuming that monetary policy (manipulating interest rates) is always the best approach to tackling inflation
Mainstream economists (for example, New Keynesian) have a tendency to treat most or all inflation as if it was demand-side driven. Often focusing on wage increases (and the workers spending those wages into the economy) as the main problem to be addressed. The main justification (I’ll examine a second justification shortly) for raising interest rates is roughly based on the following story:
Increasing interest rates will curtail business investment (due to increased borrowing costs) which in turn will lead to staff/worker lay-offs and/or pressure to reduce wages. This will lead to less money spent within the economy. The reduced spending means less competition for existing goods and services. Prices will come down as a result.
“The ECB’s monetary policy affects inflation mainly through demand. When interest rates increase, loans become more expensive and saving becomes more attractive. This lowers the demand for products – both from consumers, who spend less, and firms, which invest less. Companies can then no longer hike their prices so quickly because there are fewer people who want their products. As a result, inflation falls. But this takes time.” Isabel Schnabel, Member of the Executive Board of the ECB - European Central Bank 2022
This story may or may not be a good way to deal with demand-side inflation (the evidence is inconclusive) – but it does have a certain logic to it. However, that same logic is harder to apply to other sources of inflation (for example supply-side inflation), yet manipulating interest rates is still the go-to solution. Why is this?
Apart from what looks like an aversion to fiscal policy in general, I would say that there are two main reasons.
1. It is the central banks job to meet inflation targets
The government has given the central bank the job of meeting inflation targets. The central bank only has one tool to use; interest rates. As the saying goes, ‘when all you have is a hammer, everything looks like a nail.’ For the central bank, that translates into: if all you have is the ability to manipulate interest rates, all types of inflation look like they can be addressed by manipulating interest rates.
Of course, the aim of the policy is not to have a particular interest rate – the aim – when it comes to inflation control - is to put people out of work in order to reduce spending. This is regarded as is a simple supply and demand problem. Increase the supply of unemployed workers for the same number of jobs and you will push down wages. Lower wages means less pressure on price levels and therefore, inflation will come down.
MMT would approach this differently. For example, if inflation is being imported (i.e. a supply side issue) because imported oil prices have risen, then putting people out of work is not the best solution to bringing down or mitigating inflation.
That brings us to our second reason, rational expectations theory.
2. Rational expectations theory
Rational expectations theory suggests that if people expect inflation to rise, they will act in ways that will cause it to rise further. For example, if workers anticipate that prices will be higher in the future they will ask for wage rises in anticipation of those higher costs.
“Inflation expectations play a crucial role in our decisions. We see with some concern that more people expect inflation to exceed our 2% target also in the medium term. This makes it all the more important to send clear signals that people can rely on the ECB and that inflation will go down again.” Isabel Schnabel, Member of the Executive Board of the ECB - European Central Bank 2022
There are at least two assumptions at work here. First, it is assumed that workers understand how the economy works - and that their understanding mimics that of mainstream economists. And second, that workers will moderate their expectations about future price rises once they see that the central bank is "getting ahead of the game" by pushing up interest rates.
The idea is that workers and business owners understand that higher interest rates will bring down inflation - and, therefore, they will modify their behaviour accordingly.
This idea that workers understand the assumptions that underly orthodox economics seems like a ‘long shot’ to me. Is there any evidence supporting the rational expectations idea? If there is, it seems very hard to find.
“Empirical work has often struggled to document the role of monetary policy in determining inflation expectations, consistent with this theory. Empirical evidence in particular is sparse for non-US economies, and sometimes partial by focusing only on one particular type of agent, and thus often leads to contradictory results. This ambiguity in empirical evidence supporting the ability of monetary policy to affect inflation expectations has resulted in disagreement across monetary policymakers on the importance and effectiveness of the expectations channel for policy transmission.” Banks of England – Do inflation expectations respond to monetary policy? An empirical analysis for the United Kingdom Staff Working Paper No. 1,109 January 2025
One other thing I should mention, in passing, is the idea that increasing interest rates increase the value of the pound compared to other currencies. This is likely to push down the prices of imports, helping to lower inflation.
Ok, it’s time to have a look at the MMT approach - which also has its own ‘default approach’ to tackling inflation. That approach leans towards the use of fiscal policy (spending and taxing) as the fastest and most effective tool for controlling inflation.
The MMT approach to dealing with inflation
MMT economists are not keen to buy into the argument that monetary policy is always the best approach to tackling inflation.
And they are not even sure that monetary policy is the best option for demand-driven inflation. For example, MMT economists advocate taxes as a better way to remove demand from the economy and suggest that government spending should be targeted at areas of the economy where there are shortages rather than pumping money into areas already operating at full capacity. With this approach spending doesn’t simply bid up prices, but helps expand productive capacity where it is needed.
Evidence showing that a purely monetary policy approach is flawed
There are a number of reasons why the orthodox explanation could be flawed - including a lack of empirical data consistently supporting the approach. I’m not saying there is no evidence, i.e. there does seem to be some evidence that over the long run that raising interest rates brings down inflation. I’m saying that there is also a lot of evidence that contradicts the assertion. At best, the empirical data is mixed.
“Empirical work has often struggled to document the role of monetary policy in determining inflation expectations, consistent with this theory .” Bank of England – Do inflation expectations respond to monetary policy? An empirical analysis for the United Kingdom
Interest rate rises mean savers have more money to spend
There is a certain logic to the demand side story told by mainstream economists that increased interest rates brings down inflation - but there is also logic in what the ‘father’ of MMT, Warren Mosler has to say on the matter. I.e. increasing interest rates actually pushes prices up not down. Higher interest rates pump more money into the economy.
”What Happens When the Fed Hikes Interest Rates?The only thing that changes for the government is that the Fed…Treasury pay more interest to the economy Fed rate hikes continuously flood the economy with new money…” Warren Mosler – The 8th Deadly Innocent Fraud, MMT Conference, Leeds University July 15, 2024
Raising input costs can mean businesses raise their prices
Both workers’ wages and high borrowing are business input costs. There is evidence that suggests that when input costs go up for businesses they pass on additional borrowing costs to customers by raising their prices. Putting up business costs means prices go up not down.
“Corporations are using rising costs as an excuse to increase their prices even higher, resulting in record profits. We need limited price controls to break this cycle. The underlying economic problem is profit-price inflation. It’s caused by corporations raising their prices above their increasing costs. Corporations are using those increasing costs – of materials, components and labor – as excuses to increase their prices even higher, resulting in bigger profits. This is why corporate profits are close to levels not seen in over half a century.” Robert Reich writing in The Guardian Sept 2022
Increasing interest rates is a regressive policy
MMT advocates also point out that raising interest rates is a regressive policy - hitting low and middle income households hardest while at the same time generating more wealth for those who already own financial assets.
“Not including government, rate hikes only shift income away from borrowers who pay more interest to savers who earn more interest”. Warren Mosler – The 8th Deadly Innocent Fraud, MMT Conference, Leeds University July 15, 2024
Raising interest rates increases income for those who have savings (through higher interest payments) giving them more money to spend. At least a portion of that increased income is likely to be spent into the economy adding to the pressure on prices when goods and services are scarce.
The response to inflation must be tailored to the cause of inflation
MMT economists do not believe that there is a one size fits all solution to all types of inflation. They point out that even if interest rates were the best approach to tame inflation caused by demand side issues (which MMT does not think is the case) - most inflation is due to supply-side factors.
“In 2022, supply-side factors significantly impacted core CPI inflation in the UK, accounting for 57% of the increase, despite only 39% of the CPI basket being related to these items. This highlights that while specific goods and services were affected by supply disruptions, their weight in the overall CPI basket was less than their contribution to inflation. “ Demand and supply factors in CPI inflation, UK: 2021 to 2022 – UK Gov Office For National Statistics
So, if the problem is a supply-side issue—like importing ever more expensive energy—increasing interest rates is unlikely to be the solution. In this case, it would make more sense to invest in domestic energy production or to subsidise energy costs for businesses.
In conclusion: MMT provides a more effective and targeted approach to fighting inflation
MMT recognises that not all inflation is created equal. Different causes call for different solutions. Instead of the one-size-fits-all approach that punishes workers and slows economic growth, MMT shows how fiscal policy offers a more flexible toolkit to deal with inflation.
It highlights the role of targeted spending and taxation: taxing to reduce demand when necessary, spending where there is slack. Investing in productive capacity can help tackle structural causes of inflation such as monopoly pricing or reliance on imports.
In short, MMT doesn’t ignore inflation. It faces it head on, with tools that match the task.
That’s all for now.
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Couple of notes:
1. We should not be using the phrase "fight inflation". It's a neolib framing, and invites backwards NAIRU thinking (brainworms). Government is the source of the price level, one way or another (failure to regulate the price-setting monopolist). So it is government fighting government. If we have no power over government policy, we simply have no ammo in this "fight" except perhaps education of the masses in order to later find some such power.
2. Deflation is disastrous for the poor. Inflation is a good thing if the source is wise government policy: e.g., boost lowest wage, and inflation erodes the purchasing power of hoarded wealth, and reduces the burden of past debt. (But, why do we tolerate households in debt in the first place, if for no fault of their own except wanting to eat?)
2. Many (well-meaning) lefties get confused with monopolists marking-up their price. This is not inflation. But a bad government policy response can result in inflation, e.g, raising the interest rate floor, cutting gov spending, &c. The one-time upwards adjustment in wages required is not inflation, does not require any interest rate policy adjustment (just keep ZIRP), and technically (hence truthfully) it is just a re-gauge of the currency. If we understand this policy option then the real wage never need decline, provided base level real output per capital has not fundamentally been eroded. Failure of governments to understand is the source if the crippling austerity, not the monopoly firm fixing prices. It is government failing to regulate. I will recognise those same monopolists & oligarchs are running the government, effectively, so that is the real predicament. Our governments are illegitimate. (Nevertheless, many good decent people still get elected to office, and hired in the civil service, so we are not entirely screwed. Just mostly screwed, especially if those people are too cowardly to risk getting fired for speaking the truth.)
3. So what we need to fight, if anything, is Deflation tendencies.
4. I did a quick scan before reading (which is one way to offer a blind critique without reading the whole thing! 🤣) No occurrence of "nominal inflation" nor "real inflation". But these need to be mentioned up-front. Inflation is not a monolithic concept of "continual increase in the price level" — that is an ACADEMIC definition, but not the one most people have in their minds, right? People see one price or two go up and scream "hyperinflation!" and "end of the dollar!" — not just "people" but 90% of fintec youtube as well, even marxist youtube (Wolff, Haiphong, etc.). They are all ⓜ𝘰𝓇𝗼ⓝ𝒔 ... in that domain (maybe not in other domains).
5. The Trump/DOGE crew tried mightily to send the USD to zero and replace it with crypto, but they did not succeed. Give them 10 years and yeah, maybe they will succeed (🤫 ssshhh, don't tell them, but all they need to do is shut down the IRS and government billing operations), but only if ordinary American people have become actual zombies. That should tell you something about all the fintec pond scum and (fake)marxist bros.
So if we want to engage in actual realpolitik I think we need to be clear about this. If what people think is erosion of the real wage, or decline in the wage share, then I think this can be considered non-academic-inflation, i.e., what really concerns most ordinary people. Not the price of a bottle of Thatcher's grocery store milk, but a decline in the number of milk cartoons your whole wage cheque (or welfare hand-out) can get you. That's REAL inflation, not nominal inflation, and that is what we need to "fight." Real and Nominal can move in opposite directions. Which direction would you want? There is only one pair that directly reduces gross inequality: (–,+).
6. I honestly (perhaps naïvely?) think the best tactic in this fight is to quit your job if you can find a worker coop. Fair wage share of profits from sales. Even if your salary goes down, I think it is what I'd do in a heart-beat if I could. Worker Coops in NZ are hard to find. There are probably more per capita in the USA (just a scaling Power Law numbers thing? I'm not sure).
“Inflation does not necessarily mean that the ‘cost of living’ goes down as prices go up.” Typo? Didn’t you mean “‘cost of living’ goes up as”?