Night of the Living Keynesians

July 15, 2005

New Zealand’s finance minister recently made a hilariously quaint argument against a proposed tax cut plan—it might boost demand and unleash a bout of old fashioned Keynesian “demand pull” inflation.

Apparently Dr. Cullen hasn’t kept abreast of developments in monetary economics over, say, the last two decades, in which the notion that inflation is caused by anything other than excessive growth in the money supply has been rightfully tossed on the ash heap of history.

Thankfully, New Zealand’s National Business Review steps in to offer a lesson:

To any serious economist, this argument [that tax cuts cause inflation] is an embarrassment…

Dr Cullen has described himself as “an old-fashioned Keynesian”. Economists then were taught that the causes of inflation were ‘cost push’ or ‘demand pull’…

But how realistic is this model? The answer is, not very…

Inflation is a monetary phenomenon, as Milton Friedman demonstrated in his attack on Keynesian economics. Only central banks can generate inflation by printing money. The widespread acceptance of Friedman’s argument has led the main central banks of the world to target inflation and reduce it to low levels since the 1980s.

Non-monetary theories of inflation based on ‘demand-pull’ ideas have fallen by the wayside. They were discredited by the stagflation of the 1970s.

The reality is that there is scarcely any relationship between the state of the government’s budget and inflation in an open economy with a floating exchange rate. This conclusion is well established in the economic literature.

Read the full piece here.

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