1 Keynes Friedman "The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.

Derivation of Beveridge curve Unemployment rate = u φ = exogenous rate of job destruction Labor market “tightness” = θ = v/u Unemployed workers find jobs at rate of α = α(θ) Steady state unemployment when flows are in equilibrium: (1) which yields a negative relationship between u and v. 2

Okun’s Law over time 3 Δu = (8/16)(Δ %gap) = ½ (Δ%gap)

Final steps toward full short-run model 4 We will develop full AS-AD model as presented in Mankiw Chapter 14. We will develop model on Friday and show its properties. Equations of model: 1. ISY t = Y* - α (r t –r*) + μG + ε t 2. Cost of capital: r t = i t – π e t + risk premium 3. Phillips curve: π t = π e t + φ(Y t - Y* ) + ξ t 4. Inflation expectations: π e t = π t-1 5. Monetary policy (Taylor) i t = π t + θ π (π t - π*) +θ Y (Y t - Y* ) We did (1) in IS-LM section. We did cost of capital (2) in investment section. We do (3) Phillips curve today (but substitute Y for u). We discuss (4) expectations briefly. We discuss Taylor rule (5) on Friday and in pset.

5 Inflation’s history in the US

6 Inflation Since WW II in the US

7 How do we measure price indexes? Consumer price index: -Traditionally a Laspeyres price index (fixed weight index using early prices) -Uses the “matched model” approach -BLS has introduced an experimental index – the “chain CPI” – which is a superlative Törnqvist index. Grows more slowly than traditional CPI GDP price index -This is a Fisher (superlative) index “Core Inflation” - removes volatile food and energy and is central target for monetary policy

Why do we care about inflation? Like temperature, we care mainly about the extremes: Hyperinflation (> 50% a month) Deflation (< 0) 8

9 What are costs of inflation? Redistribution: inflation redistributes wealth from creditors to debtors (mortgages, pensions). Inefficiencies of inflation: shoe leather, menu costs, taxes,... Distinguish anticipated from unanticipated inflation (ex ante v. ex post real interest rates) Overall, costs appear relatively small at low inflation rates. Hyperinflation can destroy price mechanism Deflation can produce low-level equilibrium Fed’s “comfort zone” is 1 to 2 percent per year

10 The Expectations -Augmented Phillips Curve Inflation determined by labor/product market tightness and expected inflation. Have tradeoff between inflation and unemployment in short run, but no tradeoff in long run (Phelps-Friedman theory)

11 The short-run P.C. Graph from Economic Report of the President 1969 This was relationship that led Keynesian to believe that P.C. was a good explanation for inflation (1960s) 1.(πe)

12 Early Phillips Curve

13 Collapse of short-run P.C. This was relationship that led many new classical economists to conclude that Keynesian theories were “fatally flawed” (Lucas and Sargent. 1970s)

14 Mainstream 3-equation inflation model (1)π(t) = [w(t)-A(t)] + ε π (t) (2)w(t) = π e (t) - β[u(t) - u*] + ε w (t) (3)π e (t) = π(t-1) Endogenous variables π = rate of price inflation w = rate of wage inflation w-A = growth rate of unit labor costs π e = expected rate of inflation (or similar concept) u* = natural rate Exogenous variables A = growth rate of average labor productivity (Q/L) u = actual unemployment rate (determined by policy and shocks) ε π (t) and ε w (t) = wage and price shocks (oil prices, exchange rates, globalization, decline of unions, immigration, etc...) t = time [Note: (3) is backward looking rather than rational expectations.]

15 Simplest 1-equation inflation model Simplify price equation by assuming no shocks: (1’) π(t) = w(t) Substituting, we get: (4)π(t) = π(t-1) - β[u(t) - u*] (5) Δ π(t) = β[u(t) - u*] which is the linear expectations-augmented P.C. model.

16 u* = natural rate π 1 = π 1 e SRPC 1 Short-run Phillips curve 1

17 u* = natural rate π 1 = π 1 e Moving up short-run Phillips curve 1 2 SRPC 1,2 π2π2

18 u* = natural rate π 1 = π 1 e Short-run Phillips curve shifts upward with higher inflation expectations 1 2 π3e =π2π3e =π2 SRPC 1,2 SRPC 3

19 u* = natural rate π 1 = π 1 e SRPC 1,2 SRPC π 3 = π 3 e Now unemployment rate back to the natural rate

20 u* = natural rate π 1 = π 1 e SRPC 1,2 LRPC SRPC π3e =π2π3e =π2 u equals the natural rate in both periods 1 and 3, but the expected and actual inflation rates are higher in period 3. This diagram shows the way that the SRPC shifts as expected inflation adjusts to higher rate. Go back to the spiral curves and make sure you see why this theory predicts the clockwise loops.

21 New synthesis of accelerationist PC Rough estimate of natural rate for = 6 percent Δ π(t) = β[u(t) - u*] u* is u where Δ π(t) =0. This was the new synthesis developed by Phelps and Friedman ( ). It now forms the basis of mainstream macro for large open economies.

22 Summary on The Expectations-Augmented Phillips Curve u and π are negatively related in short run no relation between u and π in the long run short-run PC adjusts up and down as economic agents adjust their inflation expectations to reality (combination of backward and forward looking expectations). Natural rate is u at which inflation tends neither to rise nor fall

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24 Friedman on Keynes “Keynes's bequest to technical economics was strongly positive. His bequest to politics, in my opinion, was not. Yet I conjecture that his bequest to politics has had far more influence on the shape of today's world than his bequest to technical economics. In particular, it has contributed greatly to the proliferation of over-grown governments increasingly concerned with every phase of their citizens' daily lives.” (“John Maynard Keynes.” Milton Friedman, Federal Reserve Bank of Richmond Economic Quarterly Volume 83/2 Spring 1997)

25 Nobel citation on Friedman on Phillips curves “Friedman has left his mark on yet another area of the scientific debate on the causes of inflation. This concerns the course of diffusion of wage and price rises. Friedman was the first to show that the prevalent assumption of a simple "trade-off" between unemployment and the rate of inflation only held temporarily as a transient phenomenon; in the long run (more than five years) there is no such "trade-off". According to Friedman's theory, a level of unemployment which is held below a structural equilibrium level leads to a cumulative rate of price and wage increase, primarily because of the destabilizing role that expectations play. Present day formulations of wage and price determination are, in important respects, built on Friedman's hypotheses about the importance of inflationary expectations.”

26 Capitalism and Freedom "Historical evidence speaks with a single voice on the relation between political freedom and a free market. I know of no example in time or place of a society that has been marked by a large measure of political freedom, and that has not also used something comparable to a free market to organize the bulk of economic activity". ( Capitalism and Freedom, p. 9)

27 Capitalism and Freedom Capitalism and freedom is a persuasive argument against government interferences with the market place. Are you in favor social security, building levees against hurricanes, restricting addictive drugs, regulating cigarettes, licensing of doctors, national parks, minimum wage, rent controls, environmental policy, free public schooling, keeping the Federal Reserve, drivers licenses? Friedman argues against each of these as both ineffective and as undesirable interferences with personal freedoms. Friedman is the most influential “academic scribbler” behind modern libertarian thinking.