Opinion and Economic Analysis

Hicks: Inflation could precede real economic recovery

March 22, 2014

In most advanced placement high school or introductory college economics classes, we learn about something called gross domestic product. We learn that this GDP is the sum of consumer spending, investment by businesses, government spending and the net trade balance (exports minus imports).

This is true enough, and it sets up the next lesson, which is a basic model of the overall, or macroeconomy. In this very simple model, GDP gets larger if there is an increase in consumption, investment, government spending or the net trade balance.

This model is a superb way to teach the fundamentals of model building to students, so it is a great didactic tool. It can also be comforting because, like all models, it abstracts difficult ideas into digestible little pieces.

If our economic education stopped there, we’d have a nice, neat model of the economy with which to go about understanding the world. There’s just one little problem: No economists have ever used this model to explain economic growth.

A very long time ago, economists used this approach to model how a sudden drop in investment or consumption could be remedied by government stimulus. An astute reader should recognize this as the Keynesian explanation for the New Deal. But economists never, ever used this to explain long-term growth.

What is more, economists long ago rejected this model as a way to explain how stimulus might pull an economy out of recession.

Why did economics reject such a model? Well, it is not that it is too simple; simple is good. Nor is it due to fashion; this remains a fashionable model among policymakers who are innocent of economics.

The reason economists rejected this model is the plain, old-fashioned scientific method. Over and over and over again, efforts to test the model against real data proved it false. So, it was rejected and replaced by a model that has survived nearly a half century of empirical challenges.

The new model, not coincidently named the new Keynesian model, suggests that a government stimulus might work to temporarily boost consumption or investment just like the old Keynesian model does. But a very different mechanism is at work. The new model requires businesses and households to adjust their buying because of fears of expected inflation.

Applying current public policy and government spending, the new model shows that the federal government is pursuing inflation as a gateway to economic recovery. If the new model is right, we will have to face inflation before we see real recovery.•

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Hicks is director of the Center for Business and Economic Research and a professor of economics at Ball State University. His column appears weekly. He can be reached at cber@bsu.edu.

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