Slides for Part III-F Outline The New Classical view of the business cycle The Phillips curve as solution to the mystery of the missing equation Friedman’s critique of the Phillips curve The accelerationist hypothesis Friedman’s demand for money function Policy implications of the New Classical economics

The New Classical Economics, Part I The New Classical Economics part I (also know as monetarism or the New Quantity) is accurately portrayed as a refurbished edition of the Classical theory of employment and, as such, is built on the following theoretical components: Classical labor market analysis Say’s Law The quantity theory of money

Real or supply-side factors (N’, K’, R’; T) interact to determine the capacity of the economy to grow over time with price stability. The natural rate of output is the flow of output per time period that would be realized if labor markets were in a state of continuous equilibrium. Thus, the natural rate of output can be conceptualized as the inflation threshold for the macroeconomy--i.e., if the actual rate of output per time period exceeds the hypothetical natural rate, the cost- of-living will tend to rise at an increasing rate. Corresponding to the natural rate of output is a natural rate of unemployment (or NAIRU--non-accelerating inflation rate of unemployment) which is consistent with continuous equilibrium in markets for labor services. Key points

The natural rate of output is subject to change over time due to population growth, capital accumulation, the discovery of hitherto unknown natural resources, and technical change. Hence, it may be possible for real output to expand over time without inflation. A business cycle may be viewed as an episode wherein the macroeconomy is “thrown off” its long run growth path by some exogenous shock.

Time Real GDP “Natural” GDP Actual GDP New Classical concept of the business cycle A business cycle is an event in which the economy is bumped off its long-run (natural) growth path by monetary shocks

Mystery of the missing equation A frequent knock on Keynesian business cycle theory was its (alleged) failure to incorporate the price level as an endogenous variable—that is, there is no equation that links price level movements to changes in real GDP, employment, the balance of trade, etcetera. A path-breaking article by New Zealander A.W. Phillips in 1958 presented a solution to the mystery

The Phillips contribution 1 1 A.W. Phillips. “The Relation Between Unemployment and the Rate of Change of Money Wages in the U.K., ,” Economica, Nov Data points for the U.K. (annual) Unemployment rate 0 Rate of change of money wages Phillips empirical study indicated an inverse relationship between unemployment and the rate of increase of money wages

The Samuelson-Solow Contribution 1 Samuelson and Solow carried the Phillips’ work a step further by suggesting an inverse relationship between inflation and unemployment. Specifically, they estimated the following specification using U.S. data: Where  is the inflation rate and U is the unemployment rate. Hence we have a function that makes inflation a reciprocal function of the unemployment rate. 1 P. Samuelson and R. Solow. “Analytical Aspects of Anti-Inflation Policy,” American Economic Review, May 1960.

Phillips curve

The (inverted J) shape of the Phillips curve apparently gives policy makers an exploitable trade-off between inflation and unemployment. Moreover, the champions of the Phillips curve ostensibly believed that the policy trade-off was “stable”—that is, the terms of the trade- off would hold up over time

Policy target Phillips curve The (MIT) Keynesian view went like this: Find the “politically acceptable” trade-off and use “active” aggregate demand management to achieve it. Unemployment rate Inflation rate 0

3 central points: 1.The Phillips curve “harbors a fundamental defect, namely, that the supply of labor is a function of the nominal wage.” This violates a basic axiom of microeconomic theory. 2.“There is no long run trade-off between inflation and unemployment.” Suggests there may be a short-run trade- off. 3.The long run Phillips curve is vertical at the NAIRU or natural rate of unemployment. 1 Milton Friedman. “The Role of Monetary Policy,” AER, 58(1), March 1968, The Friedman critique of the Phillips curve 1 Professor Friedman delivered a blistering attack on the Phillips curve at the American Economic Association meeting in 1967

What is the NAIRU? NAIRU is an acronym for the “non-accelerating inflation rate of unemployment.” The NAIRU, or alternatively, the “natural rate” of unemployment, is that level of unemployment corresponding to equilibrium in the Classical labor market. The NAIRU is also defined as the rate of unemployment consistent with an unchanging (but not necessarily zero) inflation rate. Corresponding to the natural rate of unemployment is the “natural” level of real GDP.

The Accelerationist hypothesis Definitions U A is the actual rate of unemployment U T is the target rate of unemployment U N is the NAIRU or natural rate of unemployment  A is the actual rate of inflation  E is the expected rate of inflation LP is the long run Phillips curve SP is the short-run Phillips curve

Assumptions 1.Asymmetry of information--i.e., employers correctly forecast price level movements and employees sometimes do not. Labor is subject to “money illusion.” 2.“Adaptive” expectations on the part of labor. With respect to (2) we have Which is to say that labor adjusts to changes in the price level with a one-period lag.

Money illusion is a failure to perceive that the value of money (and hence, a given money wage) has changed

Recall we said that N S =f(w/p)—that is, labor supply is a function of the real wage, not the money wage. However, workers may not know what the real wage is at the point in time they contract for the sale of labor services. They do know the money wage. So they form an expectation of the real wage based on their estimate of the price level.

Let W E denote the expected real wage. W E =w/p E, where p E is the expected price level. Let W A denote the actual real wage. W A =w/p A, where p A is the actual price level. Labor is subject to money illusion if: W E  W A The Classical theory was (implicitly) based on the assumption that agents have perfect foresight. Prof. Friedman relaxed this assumption

Money wage 0 Employment N S (P e = 1.2) N S (P e =1.00) N D (P e = 1.00) N D (P e = 1.2) N N’ When the price level rises from 1.00 to 1.20, employers adjust immediately and increase their demand for labor. In the short-run, Y can exceed its “natural” level

 E >  A  E <  A LP  E =  A Inflation rate 0 Unemployment rate UNUN The long-run Phillips curve is vertical at the NAIRU

SP 2 :  E =12% SP 1 :  E = 3% LP  E =  A Inflation rate 0 Unemployment rate UNUN Short-run Phillips curves intersect the long-run Phillips curve at the expected rate of inflation 3 12

SP 2 SP 1 LP  E =  A Inflation rate 0 Unemployment rate UNUN UTUT 8.1 SP 3 SP 4 S Monetary deceleration produces stagflation

Monetarism took off in the 1970s The monetarists, led by Professor Milton Friedman, experienced rising influence as inflation became public enemy number 1 in the 1970s. Economists such as Edmund Phelps, Robert Lucas, and Thomas Seargent, subsequently added important modifications to the monetarist theory.

Summary Money is non-neutral in the short-run—that is, unanticipated changes in the supply of money can affect output and employment, as well as prices, in the short run. In the long-run, money is neutral. Deviations of the economy from its “natural” growth path are explained mainly by erratic or unforeseen changes in the money supply of money. Monetarists favor policy rules.