1 The Chicago School ECON 205W Summer 2006 Prof. Cunningham

2 Historical Background Theodore Schultz arrives 1943, chair Nobel Prize, Milton Friedman arrives Nobel Prize in Von Hayek ( ). Nobel Prize, George Stigler arrives Nobel Prize, Ronald Coast arrives Nobel, Gary Becker earned PhD at Chicago, returns to faculty in Nobel Prize, Robert Lucas earned his degrees at Chicago, returned in 1974 as professor. Nobel Prize, 1995.

3 Background (2) Old School vs. New School Tenets: 1.Optimizing behavior 2.Monopoly and monopsony effects are not significant. Observed prices and wages are good approximations of long-run competitive prices and wage equilibria. 3.Old school—policy, empiricism, Marshallian. New School—theory, math, Walrasian, REH. 4.Rejection of Keynesian Economics and fiscalism. 5.Limited role for government. Contributions that have lasted?

4 Milton Friedman (1912- )  Milton Friedman  mid-1950s, University of Chicago neoclassical price theorist  Establish career on PIH and the underpinnings of Marshall’s basic supply and demand model  Influenced by Frank Knight while a student at Chicago. Joined faculty there in  Money and Banking Workshop at Chicago.  Friedman is a self-proclaimed quantity theorist and classical liberal. According to Friedman, “Inflation is everywhere and at all times a monetary phenomenon.” (To the Keynesians, inflation is the result of excess demand for goods and services, and hence arises out of conditions in the real sector.) Karl Brunner coins the phrase “Monetarism”; Brunner and Alan Meltzer construct the microfoundations of Monetarism, creating a second “camp.”

5 Friedman’s Restatement of the Quantity Theory Friedman, M. “The Quantity Theory of Money--A Restatement.” In Studies in the Quantity Theory of Money, Milton Friedman, editor. Univ. of Chicago Press (1956). According to Friedman, total income (Y) is explained by nominal wealth (W) and the returns (r) that it generates. Explicitly: Y = Wr. If wealth and returns are estimated via expectations of lifelong streams, then Y is really permanent income. According to the quantity theory, money demand is proportional to the value of nominal transactions, which should be a function of permanent income.

6 Friedman, restatement (2) Friedman expands the detail of wealth and returns to indentify the variety of assets and returns in the potential portfolio: where P is the price level, r b is the return on bonds, r e is the return on equities, r a is the return on real assets, w is the ratio of human to nonhuman wealth (to capture the return on “human wealth”),  /r is total wealth, and u is the “portmanteau variable.” We can simplify this to: Note: at equilibrium, the inflation rate should be equal to the nominal return on the entire (aggregate) stock of real (physical) assets. If individuals do no suffer money illusion, they are not fooled by changes to scale, and f is linearly homogeneous in prices and nominals.

7 Friedman, restatement (3) So,. This must hold for any value of, even =1/Y. This implies that: More simply, But since Y=Py, which closely resembles the Cambridge form of the equation of exchange:

8 Friedman, restatement (4) This implies that the cash balances “constant” k, or equivalently, the circular velocity of money V in MV=Py, is really a (stable) function of a few well-defined variables. Interpretation: Over any reasonable period of time, the rates of return in this function will all move together (in “lock-step”). That is, the yield curve maintains a constant shape, even though it may shift up or down. Thus, substitutions among assets are not likely to take place except on the very short run. Therefore, f and k are quite stable, so that the results of the traditional quantity theory still obtain.

9 Friedman and the Expectations-Augmented Phillips Curve U   e =0 e=1e=1 U*U1U1 LRPC Short run Phillips curves

10 Friedman’s Constant Growth Rate Rule Argument based on permanent income hypothesis. Argument based on long and variable lags. Argument based on money as an institution. Argument based on stable money demand.

11 Robert Lucas Born in Yakima, Washington, Influenced by one of his teachers—Milton Friedman—and Samuelson’s Foundations. BA, History. PhD, Economics, Chicago. Professor at Carnegie-Mellon, Professor at University of Chicago, Editor of Journal of Political Economy since 1978.

12 Lucas (2) Brings rational expectations to macroeconomics and begins information-based modeling. Islands model. The Critique.

13 Gary S. Becker Born PhD, Chicago. Writes for BusinessWeek. Best known for five books: The Economics of Discrimination, Human Capital, Economic Theory A Treatise on the Family The Economic Approach to Economic Behavior. Believes that neoclassical theory can be used to explain all human behavior. His approach to human behavior is based on (1) rational choice, (2) market equilibrium, (3) stable preferences.

14 Becker (2) Discrimination Discriminators have a preference for discrimination. This preference will still be subject to market forces— the market will impose costs upon discriminators, reducing discrimination. Time Allocation Time used is a cost, and will be optimized. Goods-intensive commodities vs. time-intensive. Higher incomes will lead people to move to goods- intensive commodities. Time-saving conveniences can increase time. Two-worker (with high incomes) families will have a higher opp. cost to have children, so will have fewer.

15 Becker (3) Marriage Reproducing and raising children are central commodities that marriage facilitates—people form families out of self-interest. The partner with the highest market wage is most likely to engage in market work.

16 Becker (4) Fertility Children are durable capital, which add to a family’s income or welfare. Marriage partners optimize on the number of children they have based on cost-benefit analysis—they weigh the costs against the various benefits. Rural families have traditionally had more children because it is cheaper to raise children in rural areas. Welfare programs reduce the costs of having children, so increase fertility.