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March 23, 2014

Hicks: Inflation and growth

Current models can teach the basics of economic functions, but fail to illustrate the conditions for long-term growth.

Folks who write about research for a popular audience naturally tend to simplify some of the elements. This is not “dumbing down” the discussion, but rather it is allowing someone without technical training in a given area to understand just what those with that training are thinking. For example, when your physician gives you a helpful tip on wellness, she doesn’t dig into cell biology. Still, there’s always a danger in this, and one of the worst pitfalls in economics is how we think about economic growth and government stimulus.

In most AP 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, easily understood 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 work to pull an economy out of recession.

These assertions might prompt the question: Why is it that economics rejected 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.­

Michael Hicks is director of the Center for Business and Economic Research at Ball State University.

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