The Problems of Inflation Targeting Originate in the Monetary Theory of Knut Wicksell

Lars Jonung ()

No 2022:8, Working Papers from Lund University, Department of Economics

Abstract: The theoretical foundation of inflation targeting was laid out by the Swedish economist Knut Wicksell (1851-1926) in his groundbreaking treatise, Interest and Prices, published originally in German in 1898. Here he proposed price stability as the rule for monetary policy. Today, inflation targeting is considered the best-practice approach to monetary policy across the world. It has contributed to stable and low consumer price inflation since the 1990s in many countries. However, inflation targeting has recently been the subject of several objections. Most prominently, the focus on consumer price stability has fostered financial instability, as reflected in the global financial crisis of 2008-09. In addition, the sharp rise in asset prices has led to growing wealth inequality.

Why have these problems emerged? This paper provides an answer by comparing Wicksell’s theory of price level determination in a pure credit economy, the “cumulative process”, to the neo-Wicksellian world of today, characterized by inconvertible fiat money, floating exchange rates, advanced financial systems, unregulated interest rates and well-developed asset markets. In this way, it becomes apparent that the neglect of asset markets and asset prices is the source of the flaws of the present Wicksellian regime of unlimited finance. The shortcomings of the neo-Wicksellian approach can be remedied while remaining within a Wicksellian framework. The key is to combine the nominal anchor of price stability with a reformed financial system that maintains credit stability. The paper uses empirical evidence from Sweden and the United States.

Keywords: Inflation targeting; price level targeting; natural rate; Knut Wicksell; Milton Friedman; financial crises; credit; asset inflation; central banking (search for similar items in EconPapers)
JEL-codes: B10 B22 E10 E31 E40 E50 G01 G20 (search for similar items in EconPapers)
Pages: 57 pages
Date: 2022-04-11
New Economics Papers: this item is included in nep-ban, nep-cba, nep-his, nep-hpe, nep-mac, nep-mon and nep-pke
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Persistent link: https://EconPapers.repec.org/RePEc:hhs:lunewp:2022_008

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