1. VIII. End of post-war miracle and of Bretton-Woods New Classical Economics New Keynesian Economics

2. VIII.1 Neither Keynes, neither Friedman

3. Keynes: general principles Keynesian belief in demand side management Insufficient demand – expansionary policy –Fiscal: higher governmental expenditures, lower taxes –Monetary: increase of nominal money, support for the decrease on interest rates (lower the official discount, obligatory reserves of the banking sector, open market operations) Demand too high - restrictions

4. Keynes: money growth, inflation and output growth Three basic equations (see last Lecture) Keynesian framework: smoothing the cycle, stop and go policies Long term: stabilization in the logic of neoclassical synthesis Economies converge towards long term equilibria

5. Friedman: implications of expectations- augmented Phillips curve Difference from Keynesian approach: there is no permanent trade-off between inflation and unemployment –In the short-run yes, but as soon as inflationary expectations adjust, the trade-off disappears → output and unemployment returns to natural levels Crucial: how the expectations are formed? Both monetarists and neoclassical synthesis - adaptive expectation hypothesis (AEH): or

6. Policy implications By repeating back substitution: expected inflation becomes a geometrically weighted average of past actual inflations –Larger weight given to the most recent actual inflations Practical policy implication: there is a time gap between an increase in actual inflation and an increase in natural rate → allows for a temporary reduction of unemployment bellow natural rate

7. The accelerationist hypothesis The fallacy of Keynesian approach: any attempt to maintain unemployment permanently bellow the natural rate → acceleration of inflation → need for permanent increase of money growth –People will (sooner or later) adjust the expectations → to maintain unemployment under natural level → need for even higher inflation, etc. –On labor market: need for permanent real wage bellow an equilibrium level → permanent increase of wages, prices, etc. End result: permanent accelerating inflation

8. The role of monetary policies Main monetarist policy proposition: fixed rate of monetary growth, consistent with long run growth potential of the economy. Main reasons: –Steady money growth → economy settles around natural values and steady inflation –Capitalist economies are stable around natural values (compare with Keynes!) –Discretionary monetary policies may be destabilizing –As we don’t know exactly where the natural values are, attempts to stabilize unemployment may lead to inflation ↔ inflation larger evil than unemployment This certainly was an alternative to Keynes, but was a viable policy for post-1960s? Unfortunatelly not too much – see data on very high inflation together with low growth and high unemployment in almost all OECD countries in 1970s (see next slide)

9. Inflation (CPI), %yoy

10. VIII.2 B-W system: policies, end

11. Policy goals Internal balance – full employment and price stability –Different side of the same coin, unemployment → deflation, over-employment → inflation –Many other disruptive effects of internal disbalance External balance – definition: it does not have to coincide with zero current account –High CA deficit might be (very) desirable, when country is able to repay the debt financing (loans) in the future –High CA surplus might be a problem: Too low domestic investment, given total domestic savings Too many foreign claims, risk as to future payments Target for protections from abroad

12. Remark: stabilization policies under floating/fixed ExR Mundell-Flemig model The efficiency of fiscal and monetary differs according the exchange rate regime Flexible exchange rate (float) –Fiscal policy very little efficient –Monetary policy very efficient Fixed exchange rate –Fiscal policy very efficient –Monetary policy very little efficient –Changes in ExR efficient

13. 1950s B-W system: –Countries limited in their monetary policies –Adjustment to disequilibria via international reserves (gold, but mainly USD) → need for keeping reasonable level of reserves To keep reserves → limits of convertibility and of capital flows Special position of US –USD as reserve currency, main task – keeping the USD price of gold (35 USD per oz.) –Need to keep gold reserves enough –Potential constraint on US macroeconomic policy – when economies grow, will there be enough US gold reserves? Confidence problem

14. 1960s Gradual achievement of convertibility Increase of international capital flows (despite controls), more and more of speculative nature, because of expected devaluations More frequent balance of payments crises, accompanied by losses of foreign exchange reserves Devaluations, indeed (Britain November 1967) Need for policies to achieve both internal and external balance All this: crucially dependent on the performance of the US economy

15. US economy in 1960s Vietnam War, “moon racing” and Great Society program of President Johnson → strong fiscal expansion → inflation → worsening of CA → monetary policy only temporary contracted, later eased → further inflation → expected rise in USD price of gold Private speculators started to buy gold → two-tier gold market (private, where price of gold allowed to float; official, where fixed) → end of automatic constraint on worldwide monetary growth

16. US recession in 1970 1970: US recession with increase of unemployment, output falling, CA deficit → need for real devaluation of USD vis-à-vis major other currencies –Fall US prices – no way because of recession –Second option – nominal devaluation of USD, uneasy, as all other countries should be willing to peg their currency to USD at new (devalued) rate –August 15, 1971 – President Nixon stopped automatic exchange of gold for dollars and introduced import surcharge Multilateral negotiation → Smithonian agreement in December 1971 –USD devalued by 10 % against foreign currencies, price of gold increased to 38 USD per oz. Not the end of the story yet: because of continuing disequilibria, another speculative attack on USD in February 1973 → European currencies abandoned fix and by March 19, 1973 Japan and Europe floated their currencies against USD → end of B-W system

17. VIII.3 New Classical Macroeconomics

18. Historical reminder Before WWI: “classical” macroeconomics, market clearing, full employment and full employment product, vertical AS Great Depression and birth of Keynesian economics, horizontal AS After WWII: neoclassical synthesis, in the long run, the economy tends towards full employment and to vertical AS

19. Monetarist’s contribution Since 1950: continuous criticism of Keynesian propositions Alternative policy proposals Natural rate of unemployment and expectations augment Phillips curve Since the end of 1960’s: major monetarist proposition were adopted by the Keynesians –Natural rate of unemployment and expectations augmented Phillips curve fit into neoclassical synthesis –Keynesians accepted the importance of monetary policies ( along Friedman’s recommendations)

20. Reality of 1970’s Continuous high inflation and high unemployment External oil shocks (1973 and 1979) Failure of Keynesian economic policies But also monetarist recommendation seemed to be sterile when facing a new reality

21. Robert E. Lucas Jr. 1937 – University of Chicago Leading personality of “New Classical Revolution” Economist, but originally studied history Nobel prize 1995

22. Thomas J. Sargent 1943 – Teacher at several US Universities, namely Minnesota, Chicago, Stanford and New York (currently), essential advanced macroeconomic theory textbooks Rational expectations Impact on (namely) monetary policies, statistical operationality of RE, models of Phillips curve, demand for money in hyperinflations, intertemporal coordination of monetary and fiscal policies, etc. Nobel prize in 2011 (with Christopher Sims)

23. Assumptions/features In search of macroeconomic theory, rooted in micro foundations and Walrasian general equilibrium approach All economic agents optimize continuously, i.e. subject to their constraints, firms maximize profits and households maximize utility In taking optimizing decisions, agents take into account only relative prices (do not suffer from money illusion) Agents able to exhaust all profitable opportunities, wages and prices are flexible and markets continuously clear

24. Facing the challenge of reality Both Keynesian and monetary framework insufficient Consequently - see assumptions above - return to classical model, i.e. money neutral, AS and LRPC vertical But, reality (data) not consistent with classical assumptions either, namely short-run correlations –positive: price and output (upward sloping AS) –positive: nominal money supply and real GDP (non-neutral money) –negative: inflation and unemployment (downward sloping PC) New Classical solution: existence of non-neutralities given by imperfect information, agents have –A novelty, indeed: classical, pre-WWI model, always assumed perfect information

25. Three basic building blocks Rational expectations Continuous market learning New concept of aggregate supply

26. The importance of expectations Economic decisions: action today to receive uncertain return in the future –Quality of expectations crucial, most famous example: expected inflation in wage negotiations Expectation: not only one predicted value, but a probability distribution of all possible outcomes Two crucial issues –How people get, process and use information to form expectations? –What type of expectations hypothesis is most suitable for application in macroeconomics?

27. Rationale All previous models, be it neoclassical synthesis, monetarism - either explicitly or implicitly used expectations So far, PFH or AEH and - in the long run - return to potential output and other natural values Even when adjustment to past errors takes place (AEH), the errors are all the time systematically biased P e -P

28. Weak version of RE- basic idea Interpretation: subjective expectation for a variable v, made by particular agent i at previous period, is equal to the true value of v plus an error term with zero mean The objective, true conditional expectation E[.] exists, i.e. the information set Ω is sufficient to allow agent to determine E[.] Agents’ expectations are always consistent with their information

29. What makes it rational? See assumptions above - all agents are optimizers  they are also using all available information in an optimal way (best use of info) Weak version: in forming the expectations, agents perform cost-benefit analysis regarding how much information to obtain Compared to AEH, agents use all available info –AEH: learning from the past mistakes in predicting only the same variable –REH: taking into account all information, about all other variables and about all other relevant facts

30. Strong version Weak version plus assumption that all relevant information is available to the agent, namely: –A complete, true economic model of the economy and all the rules that govern the decisions of all other agents –The values of all exogenous variables till present moment (including all probability distributions, if some of the exogenous are stochastic) –Realized values of all endogenous variables (and eventual stochastic exogenous) till the present moment … in another words: “one should know everything” However, it is this strong version that is usually assumed in the model with rational expectations

31. What does it exactly mean? People DO make errors in forecast –It is NOT perfect foresight The errors are due to the incomplete information The errors are independent on the information set Ω -1 On average, agent’s expectations are correct, i.e. equal to the true values –Expectations are NOT systematically wrong over time (are not biased)

32. Rationality  optimization  equilibrium Agents –either perform an optimal search for all available information (weak version) –or just have all information from period -1 (strong version) In both cases they are (a) rational, (b) optimizing their behavior  the resulting prices and quantities are consistent with general equilibrium outcomes Consequently: all markets clear

33. Lucas’ Aggregate Supply If both firms and households have complete information, than – assuming rational expectations – the forecast is always perfect –Rational expectations with PFH, i.e. with classical model Reality –Firms: usually have complete information, including the price –Households: do not have complete information

34. Labor market Start with the classical case, i.e. full employment N * (and Y * ). In next period actual price P>P -1, known to firms, but unknown to households They can make only expectations, assume Firms: know that real wage is lower at any nominal wage → shift of N D Households: don’t know that real wage is for any nominal wage lower → do not shift N S Increase in equilibrium employment

35. N W Two comments: if price has decreased, there would be shift of N D to the left and new employment would be lower than original one if households knew the actual price, they would shift N S properly and the model is classical.

36. Aggregate supply Short run production function: Lucas’ aggregate supply: – is potential (natural) output and –Underestimation of price: –Overestimation of price: –Correct forecast: Aggregate supply of output increases with the increase of the ratio of actual and expected price level

37. Y P AS Y*Y* P=P e

38. Anticipated policies Equilibrium model with rational expectations –just on ADxAS level Suppose an exogenous change People form expectations of price changes as a consequence of change in M Rational expectation: if people anticipate the monetary policy and there is no other random shock, than they will make a proper forecast of price, because –They have full information –They don’t make systematic errors In this case, given the price changes, both AD and AS shift

39. Anticipated monetary change P Y LRAS A B C

40. Un-anticipated policies Suppose, that the change in monetary policy is not anticipated by the households and/or some random shocks appear Then households will not properly forecast the price level, but firms will → only AD shifts, but AS does not There is a new equilibrium level of employment and output as a consequence of change in the monetary policy

41. Un-anticipated monetary change P Y LRAS A B

42. Anticipated and un- anticipated policies Anticipated: households immediately adjust expectations (and behavior) –Market clearing –Vertical, classical AS Un-anticipated: households make mistake from the shock –Equilibrium moves along the positively sloped Lucas’ AS –New equilibrium output (and employment) However, given the rational expectation proposition, this is not the end of the story – in the next period, households learn their mistake and will adjust → return to Y * anyway

43. Do economic policies matter? New Classical Macroeconomics –Allows for short term fluctuations from natural values –Based on completely different theory than the Keynesian one –Consistent with microeconomic assumptions –Limited effects of governmental policies: If policies anticipated, than quick adjustment and no effect on output (and other variables) If un-anticipated policy (or some random, exogenous shock), than after some short term fluctuations adjustment to natural values anyway Policy impotence proposition – PIP

44. VIII.4 New Keynesian Economics

45. Aggregate supply in short to medium run Adjustment process (from short to long run) takes some time  question –How is the aggregate supply specified in this transition period?  increasing function of price No unified theory till today –Neoclassical synthesis: downward wage and price rigidities (no market clearing) –Phillips curve: adaptive expectations hypothesis –New Classical Economics: market clearing, rational expectations, Lucas’ AS –End of 1980s – revival of Keynes: “The New Keynesian Economics” (NKE)

46. Another view on the same problem … In the very long run: economy always at natural levels, AS vertical If AS positively sloped → money is not neutral, i.e. increase of money supply increases output (and price) and vice-versa Beginning of 1990s: NKE, 2 questions: –Is money non-neutral? Do we build the theory that denies classical dichotomy? –Do real market imperfections determine economic fluctuations The second question defines NKE: theoretical explanation of market imperfections and the link to deviations from natural values –Prices are not fixed (adjust slowly, etc.) because of short run, but because of market imperfections –Not unified theory, rather many different models and in next parts, Mankiw’s textbook is followed (see Literature)

47. Nominal wage rigidity Originally: F.Modigliani (1944) – downward wage rigidity In general: wages rigid in both directions, reasons: –Long term wage contracts, eventually implicit contracts, power of the unions Intuitively: if wages rigid, then price increase lowers real wage  firms increase employment  product increases and supply increasing function of the price

48. Wage: targeted and actual Wage negotiations: Always negotiated nominal wage at the expected price P e, so both firms and workers have in mind targeted real wage, so w T a W = w T. P e Employment given by demand  firms then decide according price P - (W/P) = w T. (P e /P) –if P = P e, then (W/P) = w T –if P > P e, then (W/P) < w T –if P w T –Unexpected growth of price means fall of real wage  higher employment  higher product; conversely, fall of price  lower product Higher price  higher AS (and vice versa)

49. N W/P A N Y Y P AS A B B

50. From wage to AS Difference between actual and expected price reflects price movements –One possible interpretation – if in moment t, expectation equals price, than actual price, determining real wage, is price in moment t+1 Generalization: Counter cyclical movement of real wage

51. Three reasons for wrong price expectations Wrong perception of price level by workers Incomplete price information Sticky-Price Model See Mankiw

52. Aggregate supply Particular models of short term aggregate supply differ, but do not exclude each other exclusively All models generate AS that – in the short run – is increasing function of price

53. Interpretation Variations from potential (natural) product are proportional to variations of actual price from expected one Actual price higher than expected  product higher than potential; and vice versa In graphical terms: short term AS is increasing, slope Expected price becomes a model parameter –When actual and expected price equal, product on potential level –Change of expected price shifts AS curve Policy conclusion: in the short-term, AD monetary or fiscal stimulation possible/desirable

54. AS in long and short term Y P LRAS AS

55. VIII.5 Conclusions End of 1960s – neither Keynesian, neither monetarist policy recomedations worked „Missing equation“ – in search of AS Core problem: explanation of short-term money neutrality and short-term positively sloped AS Basic problem – price formation and the role of wage/price expectations –Different explanations: RE or NKE Policy conclusions: –RE: only unanticipated policies matter, PIP –NKE: short-term AD managament feasible

56. Literature to Lecture VIII (1) On Keynesian policies: Blanchard, Macroeconomics, Ch. IX On monetarist policies: Snowdon, Vane, Modern Macroeconomic, Ch.4 (and literature there) On Bretton-Woods: Krugman, Obstfeld, Chapter 18 Solomon, R., The International Monetary System 1945-1976. Harper&Row 1977 Bordo, Michael D., Eichengreen, B., A Retrospective on Bretton Woods System, Chicago University Press, 1993 US economy: almost all medium level textbook of macroeconomics provide at least some case studies from this period Smith, W.L., Teigen, R.L. (1970), Readings in Money, National Income and Stabilization Policy, Richard Irwin. Chapters 4 and 5 provide the best overview of the US economic policies in 1950s and 1960s. No need to read everything, but introductions to both chapters are good to know plus articles of Okun (p.313 and 345) and of Council of Economic Advisers. European economy: Eichengreen, B., The European Economy Since 1945. Princeton University Press, 2007, Chapters 7-8

57. Literature to Lecture VIII (2) Rational expectations Snowdon, Vane, A Modern Guide to Macroeconomics, Edvard Elgar, 2005, Ch.5 verbal, relatively easy and instructive explanation Heijdra, Modern Macroeconomics, Oxford, 2009, Ch.4 slightly more formal, need to study previous three chapters as well, but very good examples See the references in both textbooks above New Keynesian Economics Mankiw, Macroeconomics, Ch.13 Snowdon, Vane, Modern Macroeconomics, Ch.7 Read parts 7.1 – 7.4. In subsequent parts the NKE is discussed in much more detail and from a slightly different angle See references in Snowdon and Vane

58. Literature to Ch. XVIII Mankiw, Macroeconomics, Ch.13 Snowdon, Vane, Modern Macroeconomics, Ch.7 Read parts 7.1 – 7.4. In subsequent parts the NKE is discussed in much more detail and from a slightly different angle See references in Snowdon and Vane