Re: Calrification from Randall Wray

["Alan G. Isaac" <aisaac@xxxxxxxxxxxx>]

On Sat, 9 Dec 2000, Henry C.K. Liu quotes
Randy Wray as saying:
>> ``the interest rate is a RATE (the rate at which one's liabilities
>> grow over time), not a LEVEL. thus, increasing the RATE cannot lead to
>> a one time shift of the LEVEL of prices. rather, it dictates the RATE
>> of price increase that will be required, all else equal, to maintain
>> solvency. in a monetary production economy, nominal prices must grow
>> at a rate that is above the interest rate.  (there is some room for
>> fudging, as some units can "die", some costs can fall, some income can
>> get redistributed, and so on)

Since this strange argument has appeared a
couple of times on this list, let us see
if it has any validity.  To keep things
conceptually simple, we will consider a firm
that produces to contract a fixed number of
widgets per year using only labor.
Also to keep things simple, labor will be
paid only once at the beginning of the year,
with funds borrowed against payment for the
product. Finally, the firm prices as a
simple markup over labor and interest costs
(where the interest expense is incurred in
order to be able to pay labor before the
product is sold).
Last simplification: we will work with a fixed
average productivity of labor.
Hopefully it is clear that these simplifying
assumptions are innocuous, in the sense that
more realistic models will imply the same
final result.

So total revenues will be
PY=(1+m)(1+i)WN
where P is price, Y is number of widgets,
m is the markup, i is the interest rate,
W is the nominal wage, and N is labor input.
Equivalently, price is
P=(1+m)(1+i)W/A
where A is the average productivity of labor.
Does an initial interest rate of say 5% imply
that prices must rise at 5% annually?
Of course not. It is clear that *any* initial
interest rate is compatible with a constant price.

Does an increase in i from say 5% to 10% imply
that prices must rise by an additional 5% annually?
Of course not. There is the one time increase in P
that several people have mentioned (including myself
in my original post to this thread), and that's the
end of the story.

Just to reiterate: I am trying to make a simple point
in the simplest possible way.  I hope any comments will
focus on the core conceptual point and not on the details
of this ``model'' (which however incorporates many features
that should be familiar to PKs).

Alan Isaac