13. THE GREAT INFLATION AND MONETARISM  The simple Keynesian models constructed in the 1930s or immediately after WW2 explained the determination of aggregate output but did not say anything about inflation.  The Phillips-curve: in the 1950s Phillips suggested – and demonstrated empirically – that there was a negative relation between inflation and the rate of unemployment  In the 1960s inflation tended to become higher without any accompanying decline in unemployment. In the 1970s inflation then accelerated to very high levels as a consequence of the first oil crisis  Stagflation: high inflation in combination with high unemployment. It was argued that this phenomenon was not explicable in terms of Keynesian economics  The credibility of Keynesianism was undermined by the high and accelerating rate of inflation

Inflation in the US and elsewhere accelerated to high levels in the 1980s

Friedman on inflation and inflation expectations  Monetarism is by and large the creation of Milton Friedman  One of his targets of criticism was the Phillips curve, the fault of which was that it was based on static expectations. Friedmans simple suggestion was that inflation expectations will adapt to actual inflation, though this may happen with a lag; for instance: p(t) = f(u – u*) + exp(p(t)) where, say, exp(p(t)) = p(t-1) so that p(t) = f(u – u*) + p(t-1)  In the short run, in period t, there is a trade-off between p and u. However, a deviation of u from u* means that p is accelerating or decelerating. So inflation is stable, p(t) = p(t-1), only if u = u*.  The expectations-augmented Phillips curve has a very simple and important policy implication: there is no long-run trade-off between unemployment and inflation.

The ’naive’ Phillips-curve

The original Phillips-curve

The short-run Phillips-curve

The expectations-augmented Phillips-curve

Expectations and the Phillips-curve

Friedman and monetarism Friedman essentially argues that the quantity theory of money is a correct explanation of long-run developments. For Friedman, the rapid and accelerating rate of inflation in the 1960s and 1970s was a consequence of a rapid rate of growth of money supply. However, in the short term money will also affect activity with time lags that are uncertain and variable. However, given large uncertainty about the length of the time lags and details of the transmission mechanism, monetary policy cannot be used for ‘fine-tuning’ of the economy. The appropriate monetary policy strategy is to aim at a stable rate of growth of the stock of money, choosing the rate of growth of money supply in such a way as to be compatible with price stability. Friedman also argued that the effects of fiscal policy were relatively much weaker than the effects of monetary policy, because fiscal policy would ‘crowd out’ private spending In short, there are several important aspects of Friedman’s monetarism: its emphasis on monetary policy and the stock of money (rather than fiscal policy), its recommendation for ‘rules-based’ policy, the view that monetary policy should take the form of a constant money growth rule, and the view of the neutrality of money in the long run (but non-neutrality in the short run).

The monetarist legacy Monetarism as a doctrine for monetary policy was influential but rather short- lived. It became clear that velocity of circulation of money – however money supply was defined – was neither a constant nor developing in a predictable way However, Milton Friedman and monetarism contributed in several ways to subsequent macroeconomic policy debates: First, monetary policy made a comeback, while less emphasis was henceforth given to fiscal policy. Second, the view that there is no long-run trade-off between inflation and unemployment Third, rules-based policy and emphasis on the role of expectations have become an important part of macroeconomic analysis and policy Fourth, monetarism was predicated on the view of a great capacity of markets to adjust rapidly towards equilibrium Fifth, Friedman consistently and eloquently argued in his popular writings for free markets and for deregulation or liberalization