Snowdon & Vane Modern Macroeconomics

tion of LM0 and IS. An increase in the money supply (which shifts the LM curve from LM0 to LM1) would result in a lower rate of interest (r1) and a higher level of income (Y1). As the interest rate falls, investment expenditure is stimulated, which in turn, through the multiplier, affects consumption and income. In the classical case, empirical studies would uncover a stable relationship between autonomous expenditure and the level of income, even though the direction of causation would run from money to income.

The Keynesian case is illustrated in Figure 4.3. The economy is initially in equilibrium at an income level of Y0 and a rate of interest of r*, that is, the intersection of IS0 and LM0. Following an expansionary real impulse (which shifts the IS curve outwards to the right, from IS0 to IS1), the authorities could stabilize the interest rate at r* by expanding the money supply (shifting the LM curve downwards to the right, from LM0 to LM1). In the Keynesian case, empirical studies would uncover a stable relationship between the money supply and the level of income, even though in this particular case the direction of causation would run from income to money. In conclusion, what the Friedman– Meiselman tests appeared to demonstrate was that (i) the marginal propensity to consume had been relatively stable and (ii) contrary to the extreme Keynesian view, the economy had not been in a liquidity or investment trap because if it had the tests would not have found such good fits for the money equation.

4.2.3 An assessment

At this point it would be useful to draw together the material presented in this section and summarize the central tenets that proponents of the quantity theory of money approach to macroeconomic analysis generally adhered to by the mid-1960s (see Mayer, 1978; Vane and Thompson, 1979; Purvis, 1980; Laidler, 1981). The central distinguishing beliefs at that time could be listed as follows:

1.Changes in the money stock are the predominant factor explaining changes in money income.

2.In the face of a stable demand for money, most of the observed instability in the economy could be attributed to fluctuations in the money supply induced by the monetary authorities.

3.The authorities can control the money supply if they choose to do so and when that control is exercised the path of money income will be different from a situation where the money supply is endogenous.

4.The lag between changes in the money stock and changes in money income is long and variable, so that attempts to use discretionary monetary policy to fine-tune the economy could turn out to be destabilizing.

5.The money supply should be allowed to grow at a fixed rate in line with the underlying growth of output to ensure long-term price stability.

The Keynesian–monetarist debate, relating to the importance of changes in the money stock as the predominant factor explaining changes in money income, reached a climax in 1970, when Friedman, in response to his critics, attempted to set forth his ‘Theoretical Framework for Monetary Analysis’. Until the publication of Friedman’s 1970 paper there existed no explicit, formal and coherent statement of the theoretical structure underlying monetarist pronouncements. In opening up the monetarist ‘black box’ for theoretical scrutiny, Friedman intended to demonstrate that ‘the basic differences among economists are empirical not theoretical’. His theoretical statement turned out to be a generalized IS–LM model which helped to place the monetarist approach within the mainstream position (see Friedman, 1970a, 1972; Tobin, 1972b; Gordon, 1974). This debate represented the ‘final big battle between Friedman and his Keynesian critics’ before the rational expectations revolution and new classical economics ‘swept both Keynesianism and monetarism from center stage’ (see Hammond, 1996). According to Tobin (1981), the central issue for both macroeconomic theory and policy is the supply response of the economy to monetary impulses. The division of such impulses between prices and quantities was referred to by Friedman as ‘the missing equation’. In Tobin’s view, Friedman’s solution to this problem ‘was not different in spirit from the wage/price/output mechanisms of mainstream eclectic Keynesian theory and econometrics’ (Tobin, 1981, p. 36).

In retrospect we can now see that Friedman’s debate with his critics demonstrated that their differences were more quantitative than qualitative, and contributed towards an emerging synthesis of monetarist and Keynesian ideas. This emerging synthesis, or theoretical accord, was to establish that the Keynesian-dominated macroeconomics of the 1950s had understated (but not neglected) the importance of monetary impulses in generating economic instability (see Laidler, 1992a). This was perhaps especially true in the UK in the period culminating in the Radcliffe Report (1959) on the working of the monetary system in the UK. According to Samuelson, a leading US Keynesian, ‘the contrast between British and American Keynesianism had become dramatic’ by 1959 because many of Keynes’s admirers in Britain ‘were still frozen in the Model T version of his system’ (see Samuelson, 1983, 1988; Johnson, 1978).

4.3The Expectations-augmented Phillips Curve Analysis

The second stage in the development of orthodox monetarism came with a more precise analysis of the way the effects of changes in the rate of monetary expansion are divided between real and nominal magnitudes. This analysis involved the independent contributions made by Friedman (1968a) and Phelps (1967, 1968) to the Phillips curve literature (see Chapter 3,

section 3.6). The notion of a stable relationship between inflation and unemployment was challenged by Friedman and Phelps, who both denied the existence of a permanent (long-run) trade-off between inflation and unemployment (Phelps’s analysis originated from a non-monetarist perspective; see Cross, 1995). The problem with the original specification of the Phillips curve is that the rate of change of money wages is determined quite independently of the rate of inflation. This in turn implies that workers are irrational and suffer from complete money illusion, in that they base their labour supply decisions on the level of money wages quite independently of what is happening to prices. In what follows we focus on the highly influential arguments put forward by Friedman (1968a) in his 1967 Presidential Address to the American Economic Association. Before doing so we should recognize just how important Friedman’s paper proved to be for the development of macroeconomics after 1968. While A Monetary History has undoubtedly been Friedman’s most influential book in the macroeconomics sphere, his 1967 Presidential Address published as ‘The Role of Monetary Policy’ has certainly been his most influential article. In 1981 Robert Gordon described this paper as probably the most influential article written in macroeconomics in the previous 20 years. James Tobin (1995), one of Friedman’s most eloquent, effective and long-standing critics, went even further, describing the 1968 paper as ‘very likely the most influential article ever published in an economics journal’ (emphasis added). Paul Krugman (1994a) describes Friedman’s paper as ‘one of the decisive intellectual achievements of postwar economics’ and both Mark Blaug (1997) and Robert Skideksky (1996b) view it as ‘easily the most influential paper on macroeconomics published in the post-war era’. Between 1968 and 1997 Friedman’s paper has approximately 924 citation counts recorded by the Social Sciences Citation Index and it continues to be one of the most heavily cited papers in economics (see Snowdon and Vane, 1998). Friedman’s utilization of Wicksell’s concept of the ‘natural rate’ in the context of unemployment was in rhetorical terms a ‘masterpiece of marketing’ (see Dixon, 1995), just as the application of the term ‘rational’ to the expectations hypothesis turned out to be in the rise of new classical economics during the 1970s. The impact of Professor Friedman’s work forced Keynesians to restate and remake their case for policy activism even before that case was further undermined by the penetrating theoretical critiques of Professor Lucas and other leading new classical economists.

4.3.1 The expectations-augmented Phillips curve

The prevailing Keynesian view of the Phillips curve was overturned by new ideas hatched during the 1960s and events in the 1970s (Mankiw, 1990). A central component of the new thinking involved Friedman’s critique of the

trade-off interpretation of the Phillips curve. This was first provided by Friedman (1966) in his debate with Solow (1966) over wage and price guideposts and had even been outlined much earlier in conversation with Richard Lipsey in 1960 (Leeson, 1997a). However, the argument was developed more fully in his famous 1967 Presidential Address. According to Friedman, the original Phillips curve which related the rate of change of money wages to unemployment was misspecified. Although money wages are set in negotiations, both employers and employees are interested in real, not money, wages. Since wage bargains are negotiated for discrete time periods, what affects the anticipated real wage is the rate of inflation expected to exist throughout the period of the contract. Friedman argued that the Phillips curve should be set in terms of the rate of change of real wages. He therefore augmented the basic Phillips curve with the anticipated or expected rate of inflation as an additional variable determining the rate of change of money wages. The expectations-augmented Phillips curve can be expressed mathematically by the equation:

Equation (4.2) shows that the rate of money wage increase is equal to a component determined by the state of excess demand (as proxied by the level of unemployment) plus the expected rate of inflation.

Introducing the expected rate of inflation as an additional variable to excess demand which determines the rate of change of money wages implies that, instead of one unique Phillips curve, there will be a family of Phillips curves, each associated with a different expected rate of inflation. Two such curves are illustrated in Figure 4.4. Suppose the economy is initially in equilibrium at point A along the short-run Phillips curve (SRPC1) with unemployment at UN, its natural level (see below) and with a zero rate of increase of money wages. For simplification purposes in this, and subsequent, analysis we assume a zero growth in productivity so that with a zero rate of money wage increase the price level would also be constant and the expected rate of

authorities reduce unemployment from UN to U1 by expanding aggregate demand through monetary expansion. Excess demand in goods and labour markets would result in upward pressure on prices and money wages, with commodity prices typically adjusting more rapidly than wages. Having re-

misinterpret their money wage increases as real wage increases and supply more labour; that is, they would suffer from temporary money illusion. Real wages would, however, actually fall and, as firms demanded more labour,

˙

unemployment would fall, with money wages rising at a rate of W1, that is,

Friedman’s analysis helped reconcile the classical proposition with respect to the long-run neutrality of money (see Chapter 2, section 2.5), while still allowing money to have real effects in the short run.

Following Friedman’s attack on the Phillips curve numerous empirical studies of the expectations-augmented Phillips curve were undertaken using the type of equation:

estimates of β of less than unity, but greater than zero, imply a long-run trade-off but one which is less favourable than in the short run. This can be demonstrated algebraically in the following manner. Assuming a zero growth

Starting from a position of equilibrium where unemployment equals U* (see Figure 4.5) and the actual and expected rates of inflation are both equal to

Now imagine the authorities initially reduce unemployment below U* (see Figure 4.5) by expanding aggregate demand through monetary expansion. From equation (4.7) we can see that, as illustrated in Figure 4.5, (i) estimated values for β of zero imply both a stable shortand long-run trade-off between inflation and unemployment in line with the original Phillips curve; (ii) estimates of β of unity imply no long-run trade-off; and (iii) estimates of β of less than unity, but greater than zero, imply a long-run trade-off but one which is less favourable than in the short run. Early evidence from a wide range of studies that sought to test whether the coefficient (β ) on the inflation expectations term is equal to one proved far from clear-cut. In consequence,

Figure 4.5 The trade-off between inflation and unemployment

during the early 1970s, the subject of the possible existence of a long-run vertical Phillips curve became a controversial issue in the monetarist– Keynesian debate. While there was a body of evidence that monetarists could draw on to justify their belief that β equals unity, so that there would be no trade-off between unemployment and inflation in the long run, there was insufficient evidence to convince all the sceptics. However, according to one prominent American Keynesian economist, ‘by 1972 the “vertical-in-the- long-run” view of the Phillips curve had won the day’ (Blinder, 1992a). The reader is referred to Santomero and Seater (1978) for a very readable review of the vast literature on the Phillips curve up to 1978. By the midto late 1970s, the majority of mainstream Keynesians (especially in the USA) had come to accept that the long-run Phillips curve is vertical. There is, however, still considerable controversy on the time it takes for the economy to return to the long-run solution following a disturbance.

Before turning to discuss the policy implications of the expectations-aug- mented Phillips curve, it is worth mentioning that in his Nobel Memorial Lecture Friedman (1977) offered an explanation for the existence of a positively sloped Phillips curve for a period of several years, which is compatible with a vertical long-run Phillips curve at the natural rate of unemployment. Friedman noted that inflation rates tend to become increasingly volatile at higher rates of inflation. Increased volatility of inflation results in greater

uncertainty, and unemployment may rise as market efficiency is reduced and the price system becomes less efficient as a coordinating/communication mechanism (see Hayek, 1948). Increased uncertainty may also cause a fall in investment and result in an increase in unemployment. Friedman further argued that, as inflation rates increase and become increasingly volatile, governments tend to intervene more in the price-setting process by imposing wage and price controls, which reduces the efficiency of the price system and results in an increase in unemployment. The positive relationship between inflation and unemployment then results from an unanticipated increase in the rate and volatility of inflation. While the period of transition could be quite long, extending over decades, once the economy had adjusted to high and volatile inflation, in Friedman’s view, it would return to the natural rate of unemployment.

4.3.2The policy implications of the expectations-augmented Phillips curve

The scope for short-run output–employment gains The monetarist belief in a long-run vertical Phillips curve implies that an increased rate of monetary expansion can reduce unemployment below the natural rate only because the resulting inflation is unexpected. As we have discussed, as soon as inflation is fully anticipated it will be incorporated into wage bargains and unemployment will return to the natural rate. The assumption underlying orthodox monetarist analysis is that expected inflation adjusts to actual inflation only gradually, in line with the so-called ‘adaptive’ or error-learning expectations hypothesis. Interestingly, it seems that Friedman was profoundly influenced by ‘Phillips’s adaptive inflationary expectations formula’ (Leeson, 1999). The adaptive expectations equation implicit in Friedman’s analysis of the Phillips curve, and used in Studies in the Quantity Theory of Money (1956), appears to have been developed by Friedman in conjunction with Philip Cagan following a discussion he had with Phillips which took place on a park bench somewhere in London in May 1952 (Leeson, 1994b, 1997a). In fact Friedman was so impressed with Phillips as an economist that he twice (in 1955 and 1960) tried to persuade him to move to the University of Chicago (Hammond, 1996).

The main idea behind the adaptive expectations hypothesis is that economic agents adapt their inflation expectations in the light of past inflation rates and that they learn from their errors. Workers are assumed to adjust their inflation expectations by a fraction of the last error made: that is, the difference between the actual rate of inflation and the expected rate of inflation.

where α is a constant fraction. By repeated back substitution expected inflation can be shown to be a geometrically weighted average of past actual inflation rates with greater importance attached to more recent experience of inflation:

In this ‘backward-looking’ model, expectations of inflation are based solely on past actual inflation rates. The existence of a gap in time between an increase in the actual rate of inflation and an increase in the expected rate permits a temporary reduction in unemployment below the natural rate. Once inflation is fully anticipated, the economy returns to its natural rate of unemployment but with a higher equilibrium rate of wage and price inflation equal to the rate of monetary growth. As we will discuss in Chapter 5, section 5.5.1, if expectations are formed according to the rational expectations hypothesis and economic agents have access to the same information as the authorities, then the expected rate of inflation will rise immediately in response to an increased rate of monetary expansion. In the case where there was no lag between an increase in the actual and expected rate of inflation the authorities would be powerless to influence output and employment even in the short run.

The accelerationist hypothesis A second important policy implication of the belief in a vertical long-run Phillips curve concerns the so-called ‘accelerationist’ hypothesis. This hypothesis implies that any attempt to maintain unemployment permanently below the natural rate would result in accelerating inflation and require the authorities to increase continuously the rate of monetary expansion. Reference to Figure 4.4 reveals that, if unemployment were held permanently at U1 (that is, below the natural rate UN), the continued existence of excess demand in the labour market would lead to a higher actual rate of inflation than expected. As the actual rate of inflation increased, people would revise their inflation expectations upwards (that is, shifting the short-run Phillips curve upwards), which would in turn lead to a higher actual rate of inflation and so on, leading to hyperinflation. In other words, in order to maintain unemployment below the natural rate, real wages would have to be kept below their equilibrium level. For this to happen actual prices would have to rise at a faster rate than money wages. In such a situation employees would revise their expectations of inflation upwards and press for higher money wage increases, which would in turn lead to a higher actual rate of inflation. The end result would be accelerating inflation which would necessitate continuous increases in the rate of monetary expansion to validate the continuously rising rate of inflation. Conversely, if unemployment is held permanently above the natural rate, accelerating deflation will