Economics of Economic Development: Endogeneity of Rate of Interest & Prices.

AuthorPadhi, Satya Prasad


Central banks are increasingly adopting some version of Taylor's rule to manage monetary prospects. The rule relies on an upward sloping Philips curve; transitional adjustment of output to potential output comes with some inflation, but there is the notion of the normal output-based real rate of interest (that corresponds to the marginal productivity theory). If the actual rate is lower, it results in Wicksellian endogenous growth of money which creates monetary instability in terms of an induced higher inflation rate. Here, also, the neutrality of money is cited: the endogenous growth of money results in increased aggregate demand that outpaces a given supply potential and results in inflation. More important perhaps, according to these hypotheses, the inflation outcome can promote further endogenous growth and results in the adverse effect on savings. The rule stipulates that there is a normal output and inflation configuration, and the central banks should intervene (i.e. rate of interest adjustment) to control endogenous money if aggregate demand is outpacing such normal output (and inflation).

There is some basic post Keynesian critique, which also holds on to an upward sloping Phillips curve (Setterfield, 2004). If such endogenous money-led aggregate demand outpaces the existing normal output, it can also be normal when it anticipates (and actualizes) higher growth prospects. That is, evolution of better supply responses necessitates a condition where aggregate demand should necessarily outpace existing supply condition (Lavoie, 2006). In this point of view, endogenous growth of money is a phenomenon that has to be "promoted" (or, to be acquiesced by the central bank), to support transition to higher growth phases.

In this critique, Taylor's rule negates the possibility that realized output would be associated with some endogenous money-led excess aggregate demand, which otherwise permits further expansion of output and employment. There is then the implicit suggestion of a permissive (read, low) rate of interest that induces the transition to higher growth phase (with some inflation). However, the existing post Keynesian literature belongs to a different universe of discourse. In the existing post Keynesian, mainly horizonatalism literature, the extent of the endogenous money supply, in response to demand originating in production, takes place at a given rate of interest; the central bank's accommodating stance is with respect to adjustments of reserve requirement when "commercial banks" extend higher credit that is independent of savings deposits (Kaldor, 1970; 1983; Lavoie, 1984; Rochon, 2004). However, a coherent story of such endogenous money supply thesis can permit an alternative aggregate demand framework that can undermine Keynes's analytical tools (Moore, 1988; 1994); there is much debate and dissents within these post Keynesian schools on the issue of relevance of Keynes's insights in to the endogenous money thesis (for example, Cottrell, 1994; 1994a); (however) the present paper has no comments to offer, unless they relate to the rate of interest issue.

Why not incorporate the suggestion of a low interest rate, or interest rate as a variable, in the post Keynesian perspectives? Why not study and specify a process that endeavors to achieve higher development status, study whether it enjoins endogeneity of money in a fundamental sense, and study the implications to see whether it provides an alternative to the Taylor's rule? The present paper proposes that the post Keynesian challenges to the Taylor's rule should focus primarily on the study of economic development processes that underline the non-neutrality of money. The latter indicates a fundamental endogenous money thesis that forms a broader interpretation of Keynes's independent investment (i.e. independent of savings and such bank deposits) that enables the income determination process. The role of money shows that it by definition comes forth in response to demand originating in production i.e. its supply is endogenous (Keynes, 1937; Davidson, 1986). The present paper would argue that an economic development process would also incorporate Keynes's insights and analytical tools, in a fundamental sense. Such a thesis would hold that monetary prospects should determine the rate of interest; if so, a consistent post Keynesian understanding would be that changes in monetary prospects in different phases of economic development process would induce corresponding changes in rate of interest, so that (endogenous) money supply is attuned to the development prospects.

An argument could be: in endogenous money thesis, if supply adjusts to demand, there is no scope of liquidity preference (and so a discussion of Keynes's monetary prospects-led rate of interest adjustment is en passe). However, the present paper's counter argument could be: Keynes's insight into liquidity preference, or conversely, willingness to hold bonds, should not be undermined in an endogenous money thesis. If agents hold on to favorable future growth expectations, the implicit pressure on liquidity preference is low (or desire to hold bonds is high), and therefore, a low interest rate (guided by these expectations) induces higher endogenous money that is in line with higher current demand for money (or higher expected production), which conforms to Keynes's short run logic. Conversely, when expectations are unfavorable, and current production related demand for money is low, a high rate of interest would keep the supply (of money) in line with the low demand. Therefore, if changes in rate of interest are guided by changes in expectations (and the implicit pressure on liquidity preference), rate of interest plays the key role in bringing the (endogenous) supply of money in line with the demand.

If so, the logic demands, and the insight into the process would hold that a low rate of interest permits higher extent of money supply that provides the permissible environment for high investment-led high growth phases (i.e. there should not be any coordination mismatch between the real and the money aspects --in a monetary production economy). A related point is central banks' policy rate should play an accommodating role, guided by the underlying favorable expectations, held both by agents of production and banks. The present paper is an elaboration of these themes.

It should be stressed that in the existing (post Keynesian) literature, there is no attempt to discuss the issues of whether kick starting a development process fundamentally depends on non-neutrality of money per se, how exactly the monetary prospects peter out, and whether the pro cess as a whole provides a critique of the basic assumptions underlying Taylor's rule. The present paper in fact would take a lead to show that economic development has to emphasize Keynes's fundamental non-neutrality money axiom and can incorporate most of the analytical tools that are follow-ons. This exercise can be important if the issues are: would the evolution of interest rate be pro-cyclical or anticyclical in the economic development process? Does this interest rate formation provide the challenge to the marginal productivity theory-based interest rate formation underlying the Taylor's rule? There are in fact no exiting post Keynesian discussions on these issues.

Similarly, should inflation be viewed a monetary demand-led outcome per se? In the above post Keynesian critiques, for instance, the possibility of credit-led inflation, and growth-inflation trade-off, is acknowledged. However, it would be argued later that inflation would be manageable; the induced better supply responses would dampen any inflationary expectations. So, what is the basic source of inflation that is more problematic? Can it be traced to improper development processes (Kaldor, 1976)--alluding at real factors as the basic cause, as compared with that of the Taylor's rule emphasis on inflation as always a monetary phenomenon? An added inquiry could be: does improper development induce monetary mismanagement that in turn results in inflation (that comes with higher inflationary expectations)?

Further, if money is important in the economic development process, the is sue of stability of money (and financial system) is also important. Here, again, the existing post Keynesian literature on endogenous growth of money remains silent on this issue--because the growth entails certainty of profits (and savings). However, does every expansion, embedded in the credit nature of money, ensure certainty? Does sometimes the nature of induced development process create the problems? Does the hyper-inflation possibility emanating from real factors is the issue/cause?

Given these understandings, the purpose of the present paper is to illustrate a "post Keynesian" economic development process to study the underlying evolution of the monetary prospects of rate of interest and price level. The issue is: how the economic development perspective provides an alternative monetary policy focus.

The present paper does not start in a vacuum. There have been earlier discussions of the economic development processes that form the genesis of a monetary production economy. First, Schumpeter (1934) provides such an account, determining in turn the monetary economy conceptual entities, such as rate of interest, savings, and inflation. However, though Schumpeter's stress on the departures from static adjustments is what inspires the present paper, and is illuminating, the Schumpeterian determination of the interest rate, in a pure dynamic setting, has its limitation. A more satisfactory discussion of innovation-led economic development processes can be traced to Young (1928), a context that Kaldor (1972) shows has to be embedded in a monetary production economy framework. However, Kaldor never carried forward the analysis, for the purpose of determination of rate of...

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