The Macroeconomic Policy Model

Godley brought a large part of what came to be the CEPG or ‘New Cambridge’ model of the UK economy in the 1970s to Cambridge from the Treasury. Key features of the model were set out formally in Cambridge Economic Policy Review No. 1 (CEPG 1975: 85-91) and an article published in Economica (Cripps and Godley 1976). Extensions and refinements were written up in subsequent issues of the CEPR and the 1983 Macroeconomics book. Further development of financial aspects by Godley and others gave rise to the 2007 Monetary Economics book (Godley and Lavoie 2007a).

Price Setting, Inflation, and Real Income

A big issue of the 1960s and 1970s was the persistence of inflation while unemployment rose. Godley paid a lot of attention to the mechanics of price increases, in particular the degree to which they were demand-determined or cost-determined and the manner and timing of the passing on of costs into prices. He learned something about price formation from Andrews as a student at Oxford and made systematic investigations while at the NIESR in 1964. Further empirical research on pricing behaviour with Ken Coutts at Cambridge was eventually written up in a book (Coutts et al. 1978). The book was a theoretical and statistical development of Andrews’s normal cost pricing hypothesis. The key idea was that firms set prices to maintain given margins over ‘normal’ unit costs, calculated on actual wages and input prices but assuming normal productivity. This hypothesis implies that the profit share will vary on account of cyclical fluctuations in productivity as employment adjusts less than fully to changes in output. It also implies that real wages are more or less given by normal productivity and profit markups irrespective of the rate of wage or price inflation. As in the case of trade, there were some important qualifications to do with timing (stock appreciation), world prices, and exchange rates (cost of imports and profitability of exports). In particular, in the analysis between historic unit costs and prices, lags were derived from inventory-sales ratios without using econometrics at all.

The CEPG developed an analysis of relationships between inflation and the level and distribution of real income in response to events in the early 1970s when the UK government guaranteed real earnings through an indexation scheme at a level that the economy could not deliver—the outcome being rapid escalation of inflation to reach a peak rate of more than 25% per annum in 1974. Godley understood that inflation neutrality could provide a valuable benchmark for understanding how inventories and work in progress should be financed and other components of national income such as interest and taxes should be adjusted in order to minimize impacts on real income and spending. The CEPG’s model provided a relatively complete picture of income, expenditure, and financial balances measured in terms of a purchasing power standard. Relative price changes were an important part of the real economy story, but inflation in the sense of general changes in the price level was a distinct issue.

Although a lot of attention was paid to price adjustment and inflation accounting, Godley never had a strong theory of inflation as such. Inflation neutrality provided a behavioural benchmark but not a powerful predictor. Workers and employers may agree on adjustments intended to achieve or maintain target levels of real earnings, but there is no self-evident way of determining how fast target earnings should be expected to rise. Interest rates may (or may not) be adjusted to maintain normal real rates. In general, nominal adjustments cannot be fully effective in achieving real targets unless the level of real income determined by gross domestic product (GDP) (with adjustments for external income flows and the terms of trade) matches or exceeds the grand total of target real incomes. Inflation in the UK was widely regarded, not only by the CEPG, as resulting from the pursuit of improved levels of real earnings with money rates and earnings being increased regularly in a wage-price spiral. Incomes policies which sought to generate acceptable levels and relativities were not able to keep inflation at a low level.