The Sorry History of Macroeconomics II

The Sorry History of Macroeconomics II
Steve Keen

The Phillips Curve Given a priori expectation that nonlinear “factor-price”—price inflation relationship should exist, Phillips went looking for it in data Collated seven separate series to form base UK data set Rejected one set because the “relation hardly appears at all using the Phelps Brown and Hopkins series” (1958, 291; Fig. 4, 287) Many other data quality issues… data selection & analysis loaded in favour of finding more stable relation than even his analysis implied… Phillips not trained in statistics beyond exposure in engineering degree…

The Phillips Curve “The ‘weekend’ in 1958 during which Phillips made his calculations may well have been the first occasion on which Phillips analysed economic data with a view to writing about them. The Phillips curve was not constructed by someone who regarded himself as a statistician, or an econometrician, or even an economist. Phillips regarded himself (and was regarded by his contemporaries) as an engineer, constructing ingenious optimal control solutions to the stabilisation problem…” (Leeson 1998) Ironic that so pivotal an econometric argument derived by non-econometrician… Technical limitations in late 1950s meant actual analysis of data also quite limited:

The Phillips Curve Phillips hypothesised three factors which might influence rate of change of money wages: 1. Level of unemployment (highly nonlinear relationship) 2. Rate of change of unemployment 3. Rate of change of retail prices “operating through cost of living adjustments in wage rates… when retail prices are forced up by a very rapid rise in import prices … or … agricultural products.” [Economica 1958 p ] Overall cost-based perspective on prices Only 1st of 3 causal factors shown in curve Other factors discussed verbally but not incorporated in regression

The Phillips Curve In particular, “wage-price spirals” acknowledged in paper: “the wage increase in 1862 is definitely larger than can be accounted for by the level of unemployment and the rate of change of unemployment, and the wage increase in 1863… It seems that the 12.5 per cent increase in import prices between 1861 and 1862 … connected with the outbreak of the American civil war… was in fact sufficient to have a real effect on wage rates by causing cost of living increases in wages … … the consequent wage-price spiral continued into 1863.” (291; e.a.) Also spoke of lagged impact of import prices on inflation and then on money wage change:

The Phillips Curve “in 1948 the cost push element was considerably greater than the demand pull element, as a result of the lagged effect on retail prices of the rapid rise in import prices during the previous year, and the change in wage rates was a little greater than could be accounted for by the demand pull element…” (297) But rate of change of unemployment; & lagged response of wages to price changes omitted from regression… For obvious reasons: Any function of 3 variables could fit < 100 data points Such calculations not possible without computers

The Phillips Curve Nonetheless, Phillips found a “clear tendency” for
inverse relation between U and rate of change of money wages (Dwm) Dwm above curve when U falling, and v.v Fitted single variable exponential curve to data: Unemployment Dwm Data itself not shown in paper (except for most recent decade ) only visually compelling graphs:

The Phillips Curve “Keynes warned of the
"horrid examples of the evils of the graphical method unsupported by tables of figures. Both for accurate understanding and particularly to facilitate the use of the same material by other people it is essential that graphs should not be published by themselves but only when supported by the tables which will lead up to them. It would be an exceedingly good rule to forbid in any scientific periodical the publication of graphs unsupported by tables" (JMK XI [1938], 234). Phillips (1958, 298, Table 1) did, of course, present a table of data for the years ; but his essay was powerful because of its visual impact: the data appeared to be magnetically attracted to the curve.” (Leeson; emphasis added)

The Phillips Curve Deviations from trend because of:
Fitted through average wage change & U for 0-2,2-3,3-4, 4-5,5-7,7-11% unemployment Wage-price spiral due to wars; falling U Rising unemployment Curve then extrapolated to later 19th century data:

The Phillips Curve fitted to 1913-1948 data
Rapid rise in U; 13% fall in M prices; “cost of living” agreements War-induced rise in M prices

The Phillips Curve: 49-57 data with time lag
Close fit of 50s UK data to curve was very persuasive Import price rise But as Leeson argues, could also be seen as “vertical line” at full employment

The Phillips Curve Conclusion: Phillips extrapolates from money wages to price inflation: “Ignoring years in which import prices … initiate a wage-price spiral, which seems to occur very rarely except as a result of war, and assuming an increase in productivity of 2% p.a., … [for] a stable level of product prices … unemployment would be … 2.5%. [For] stable wage rates … about 5.5%” [p. 299] An inflation-unemployment trade-off? But Phillips’ main purpose for developing it was to provide an input for his dynamic models in which unemployment, output, etc., varied cyclically.

The Phillips Curve Let’s test impact of Phillips’s curve on dynamic model replace invented linear relation in previous model with nonlinear (exponential regression) on data: You can almost “see” the curve…

The Phillips Curve Nonlinear regression has reasonable correlation:

The Phillips Curve Put into model and (with some tweaks to parameters…) This (& Phillips’s original models) far removed from standard economics “comparative statics”

The Phillips Curve Phillips’s colleague R.G.D. Allen wrote:
“Until the engineer’s experience is appreciated and assimilated, there is little hope that the economist can develop macrodynamic models to the point where there is a chance of practical application” (1955, 168) Curve should have been no more than justification for using nonlinear unemployment-wages relationship in dynamic model Alternative, superior methodology to comparative statics Instead made basis of (static, mechanical) economic management 1. Enter desired level of employment 2. Read off matching rate of inflation 3. Increase money supply by that much +3% (to account for productivity increase…)

The Phillips Curve Mechanistic interpretation quickly made part of “Keynesian” orthodoxy Possible appeal simplicity: reduced macroeconomic management to simple “trade-off” Appeared to work from 59-68 But then “breakdown” appeared to occur:

The Phillips Curve: Breakdown…?
However proper reading of Phillips indicates “breakdown” interpretation invalid ( as well as mechanistic) OPEC I Had 2 other causal factors: Rate of change of rate of employment “cost of living adjustments in wage rates” (283-4)… Vietnam war OPEC II Boom Years

“The purpose of the present study is to see whether statistical evidence supports the hypothesis that the rate of change of money wage rates in the United Kingdom can be explained by the level of unemployment and the rate of change of unemployment, except in or immediately after those years in which there was a very rapid rise in import prices, and if so to form some quantitative estimate of the relation between unemployment and the rate of change of money wage rates…” (284; e.a.)

Let’s consider whether Phillips’s (flawed) data supports additional causal factors: Rate of change of rate of unemployment Presence/absence of wars (import price rises) ignored as more arbitrary But could model using wage-price-productivity feedback mechanism in more complex model (Could also use “dummy variable”, but very arbitrary way to treat very unique events) Rate of change of rate of unemployment: “1st difference” of yearly unemployment rate First, isolate residuals of data on wage change from “1 dimensional Phillips curve” prediction:

Plot residuals against “1-dimensional Phillips curve” Derive change in unemployment & plot against residuals of 1D regression:

Expected negative relationship vaguely visible Rising UFalling Wages Not much of a relationship, but let’s proceed…

Linear regression on residuals Some correlation, so try 2D nonlinear regression: Using values of separate regressions as guesses: Slight increase in correlation: Fit new 2D function of U and dU What impact does this have on flowchart model?

A lot!: And not just on system stability…

Phillips “curve” no longer simply a curve… Anywhere in this region consistent with Phillips relation… Could get outside it with “wage-price spirals” due to wars etc.

Phillips “Curve” doesn’t look so “broken down” any more… Didn’t “break down”… was “assassinated” Economists in general didn’t comprehend Phillips’s dynamics Neoclassicals used apparent breakdown to reassert “money neutrality”

Generalised Phillips curve easily copes with (U, dW) combinations like U=5%, dW=-3.5%; and U=5%, dW=+6% “wage-price spirals” due to Vietnam War OPEC… could explain data outside Phillips surface Well within historical range of post “breakdown” data (However, relation will of course change with Differing institutional arrangements Changing absolute income levels (19th century UK workers income similar to 3rd world today) Changing political power…) Phillips’s conclusion thus still in general justified:

“The statistical evidence … seems in general to support the hypothesis … that the rate of change of money wage rates can be explained by the level of unemployment and the rate of change of unemployment except in or immediately after those years in which there is a sufficiently rapid rise in import prices to offset the tendency for increasing productivity to reduce the cost of living.” (299; e.a.) Unfortunately, curve not interpreted as nonlinear component of dynamic model but as simple & rigid “trade-off” between inflation & unemployment… Phillips unwittingly contributed to this interpretation:

“Ignoring years in which import prices rise rapidly enough to initiate a wage-price spiral, which seem to occur very rarely except as a result of war, and assuming an increase in productivity of 2 per cent. per year, it seems from the relation fitted to the data that if aggregate demand were kept at a value which would maintain a stable level of product prices the associated level of unemployment would be a little under 2 per cent. If, as is sometimes recommended, demand were kept at a value which would maintain stable wage rates the associated level of unemployment would be about 5 per cent.” (299; e.a.)

Apparent breakdown of relationship in late 60s-70s assisted rise of Monetarist economics First phase: Friedman’s “adaptive expectations” explanation for alleged “shift” in Phillips Curve… Reasserts Walrasian equilibrium vision of economy “Natural” tendency to full employment Defined as supply of labour = demand Supply determined by household preferences Demand: marginal product of labour = demand curve for labour under perfect competition Money sets absolute price level only Key paper “The Optimum Quantity of Money” (1969) Stylised equilibrium model of economy Most important point—assumed nature of money:

Monetarism: The Movie “I. HYPOTHETICAL SIMPLE SOCIETY
Let us start with a stationary society in which there are (1) a constant population with (2) given tastes, (3) a fixed volume of physical resources, and (4) a given state of the arts. It will be simplest to regard the members of this society as being immortal and unchangeable. (5) The society, though stationary, is not static. Aggregates are constant, but individuals are subject to uncertainty and change. Even the aggregates may change in a stochastic way, provided the mean values do not. (6) Competition reigns. To this fairly common specification, let us add a number of special provisions:…” (Friedman 1969: 2) (12) All money consists of strict fiat money, i.e., pieces of paper, each labelled “This is one dollar.” (Friedman 1969: 3; e.a.) Whatever happened to credit money???

Monetarism: The Movie Key aspect of Milton’s assumed Paradise:
No debt-based money Money created by non-economic entity (ultimately government) Model’s domain (see HET Methodology lecture) therefore world without credit money, fractional banking Is that our world? Not now—and probably never! Consider ratio of debt to M1 (“Fiat money”—currency—roughly 40% of M1) in USA:

Monetarism: The Movie Even in 1975, Debt:M1 ratio almost 6 to 1
Now over 14:1; Debt:Currency ratio about 50:1!

Monetarism: The Movie Milton’s “fiat only” fiction a counter-factual “assumption” Affects validity of results Proposes optimal inflation rate of… Minus 5 per cent p.a.! “At an internal rate of discount of per cent, the optimum quantity of money would be attained with a rate of price decline of 5 per cent per year…” (42; e.a.) In fiat money only world, no one suffers—real value of money holdings rises for all agents In credit money world, debtors suffer Real burden of debt increases: Fisher’s “Debt Deflation Hypothesis” Model irrelevant to credit money real world

Monetarism: The Movie Ditto assumption that “uncertainty and change” means “aggregates may change in a stochastic way, provided the mean values do not” Remember Keynes on pre-Keynesian (neo)classical theory & treatment of time: “I accuse the classical economic theory of being itself one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future.” (Keynes 1937: 215) Friedman resurrects pre-Keynesian approach on back of “breakdown” of Phillips Curve…

Monetarism: The Movie Back to model: a Walrasian vision of economy:
“Let us suppose that these conditions have been in existence long enough for the society to have reached a state of equilibrium. Relative prices are determined by the solution of a system of Walrasian equations. Absolute prices are determined by the level of cash balances desired relative to income.” (3; e.a.) Renewal of (neo)Classical dichotomy: Real output determined solely by real factors Price level determined solely by monetary factors Monetary factors have no impact on real output Stability of Walrasian system assumed (see Advanced Political Economy lecture on instability of General Equilibrium)…

Monetarism: The Movie Money held only “to serve as a medium of circulation … in order to a the famous “double coinci dence” of barter.” (3) Money demand now a fraction of income: “If we identify the money in our hypothetical society with currency in the real world, then the quantity of currency the public chooses to hold is equal in value to about one-tenth of a year’s income, or about 5.2 weeks’ income. That is, desired velocity is about ten per year.” (4) Remember Hicks’s “typical classical theory”: MD=k.I? Keynes’s precautionary, speculative and finance motives for money “out the window” Next, what happens if quantity of money increased?... Start with nominal Y=$10,000 & M=$1,000

A helicopter?!!! Monetarism: The Movie
“Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated…” (4-5) A helicopter?!!! Money completely exogenous (to market system) vs Circuitists (see Advanced Political Economy lectures): Money created by extension of bank credit Banks and endogenous money creation essential aspects of capitalism… Back to Milton’s Paradise…

Monetarism: The Movie Money stock now rises to $2,000; what happens?
“Consider the “representative” individual who formerly held 5.2 weeks’ income in cash and now holds 10.4 weeks’ income… The assumption that he was in a stable equilibrium position before means that he will now want to raise his consumption and reduce his cash balances until they are back at the former level. Only at that level is the sacrifice of consuming at a lower rate just balanced by the gain from holding correspondingly higher cash balances.” (5) So holding on M a utility-maximising decision Marginal utility of cash balance = marginal disutility of holding cash…

Monetarism: The Movie “each individual will seek to reduce his cash balances at some rate … by trying to spend more than he receives. But one man’s expenditure is another man’s receipt…” (5) Spending by each individual drives up prices… “People’s attempts to spend more than they receive will be frustrated, but in the process these attempts will bid up the nominal value of services. The additional pieces of paper … make no additional productive capacity available. They alter no tastes… Hence the final equilibrium must be a nominal income of $20,000 instead of $10,000, with precisely the same flow of real services as before.” (6) So much for a single helicopter; what about a stream of them?

Monetarism: The Movie “the dropping of money, instead of being a unique, miraculous event, becomes a continuous process, which, perhaps after a lag, becomes fully anticipated by everyone. Money rains down from heaven at a rate which produces a steady increase in the quantity of money, let us say, of 10 per cent per year…” (8) If “Individuals … respond … by keeping real balances unchanged… all real magnitudes could remain unchanged. Prices would behave in precisely the same manner as the nominal money stock. They would rise from their initial level at the rate of 10 per cent per year…” (9) Inflation driven by expectations of inflation:

Monetarism: The Movie “One natural question to ask about this final situation is, “What raises the price level, if at all points markets are cleared and real magnitudes are stable?” The answer is, “Because everyone confidently anticipates that prices will rise.”” (10; e.a.) Depreciation of nominal balances by inflation raises holding costs of money: “Storage and depreciation costs are now ten cents per dollar per year, instead of zero, so he will try to hold a smaller real quantity of money. Let us suppose, to be specific, that when prices are rising at 10 per cent a year, he desires to hold 1/12 instead of 1/10 of a year’s proceeds from the sale of services in cash balances, ie., 4 instead of 5.2 weeks’ income.” (11) Which causes further inflation…

Monetarism: The Movie “The attempt of individuals to reduce cash balances will simply mean a further bidding up of prices and income, so as to make the nominal stock of money equal to 1/12 instead of 1/10 of a year’s nominal income…” (12) Milton quantifies losses as a result of helicopter inflation Cost of deflated value of dollars held (10% p.a.) Consumer now adjusts holdings of cash downwards because of holding cost Average value of dollars foregone halfway between old cost (zero) and new (10%) so 5% on-going cost from 10% inflation Now he starts to praise deflation:

Monetarism: The Movie “When prices are stable, one component of the cost is zero—namely, the annual cost—but the other component is not—namely, the cost of abstinence. This suggests that, perhaps, just as inflation produces a welfare loss, deflation may produce a welfare gain. Suppose therefore that we substitute a furnace for the helicopter… to yield … a steady decline in the quantity of money at the rate of, say, 10 per cent a year…” (16; e.a.) Deflation makes money grow in value: “When prices are declining a dollar of cash balances yields a positive return. The real services that a dollar of balances will command grow at a rate of 10 cent per year.” (17) Therefore people will want to hold more money…

Monetarism: The Movie Leading to a demand curve for “real cash balances” as function of rate of inflation: Implies limitless deflation a good thing, but… “Beyond some point, it pays individuals to hold extra balances … even if it costs something to do so. The retailer dispenses with an errand boy to economize on cash balances, … but, at some point, he must hire guards to protect his cash hoard… The extra real balances not only do not save productive resources, they absorb them.” (17)

Monetarism: The Movie Marginalism to the rescue: “representative agent” balances marginal gain from rising real value of cash under deflation with marginal cost… Components of marginal decision are (pp ): Anticipated rate of price change P “The productive services rendered per year by a dollar of cash balances as factor of production” MPM “The non—pecuniary consumption services to the holder of cash balances.” MNPS “The cost of abstaining from a dollar of consumption... his internal rate of discount” IRD Milton thus proposes constrained utility-maximisation equation:

so that because Monetarism: The Movie
Milton concludes that “cash balances of the fiat money will be at their optimum level in real terms when” so that because “cash balances will be at their optimum when they are held to satiety, so that the real return from an extra dollar held is zero.” (21) In Milton’s Paradise, IRD=0 for “the “rational” individual” because economy is stationary… Milton next introduces lending “(a) to finance extra consumption, or (b) to finance the holding of cash balances as a productive resource.” (24)

Monetarism: The Movie “We finally have a market measure of the internal rate of discount—that rate of steady price decline that makes the nominal interest rate equal to zero.” (33) Then “Reproducible capital goods” (so that there is a return on equities) Ideal equilibrium now becomes Such that rB=0; then “optimal” rate of price deflation should equal return on equities Under the assumptions that…

Monetarism: The Movie “the cost of capital to a firm is independent of the debt-equity ratio. This is a very special case of the much more general proposition to this effect asserted by Franco Modigliani and Merton Miller. Our result reflects the assumption that both bonds and equities are default-free… (35) We’re still in Paradise then—no uncertainty… What about credit money? “Money in the form of demand deposits adds no special complexity.” (37) What about growth?

Monetarism: The Movie “We can relax the usual stationary state restrictions without altering the basic conclusion. Substitution of individuals with finite lives for immortal individuals gives a possible reason to expect a positive internal rate of discount. Growth in population, capital, and technology means we must consider a moving dynamic equilibrium instead of a stationary one…” (37) With again, no change to the analysis… Thus Milton believes model can be applied to real world Effective policy recommendation Reduce money stock by 5-7% p.a.

Monetarism: The Movie “The rough estimates of the preceding section indicate that that would require for the U.S. a decline in prices at the rate of at least 5 per cent per year, and perhaps decidedly more.” (46) However, a smidgen of reality seeps in Costs of reducing prices all the time; Adjustment costs of transition from current inflationary world… “These practical considerations, I believe, make it unwise to recommend as a policy objective a policy of deflation of final-product prices sufficient to yield a full optimum in the sense of this paper.” Instead… “A policy fairly close to the optimum would probably be to hold the absolute quantity of money constant…” (46)

Monetarism: The Movie But maybe this is too drastic too…
“However, this policy, too, seems to me too drastic to be desirable in the near future although it might very well serve as a long-term objective. A more limited policy objective might be to stabilize the price of factor services… this would require a rise in the quantity of money at the rate of about 2 per cent per year.” (46) And finally, maybe half way there is good enough… “I have favored increasing the quantity of money at a steady rate designed to keep final product prices constant, a rate that I have estimated to be something like 4 to 5 per cent per year … for a monetary total defined to include currency outside of banks and all deposits of commercial banks, demand and time.” (47)

Monetarism: The Movie “The gain from shifting to the 5 per cent rule would, I believe, dwarf the further gain from going to the 2 per cent rule, even though that gain may well be substantial enough to be worth pursuing. Hence I shall continue to support the 5 per cent rule as an intermediate objective greatly superior to present practice…” (48) Milton’s Monetarism adopted by Thatcher’s UK, Reagan’s USA in mid-70s. USA application clouded by huge government deficits UK clearest example of actual impact Kaldor put it best:

Monetarism: The Reality Show
“The great revival of "monetarism" in the 1970s, culminating in the adoption of the strict prescriptions of the monetarist creed by a number of Western governments at the turn of the decade—particularly by President Reagan's administration in the United States and Mrs. Thatcher's in Great Britain—will, I am sure, go down as one of the most curious episodes in history, comparable only to the periodic outbreaks of mass hysteria (such as the witch hunts) of the Middle Ages. Indeed, I know of no other instance where an utterly false doctrine concerning the causation of economic events had such a sweeping success in a matter of a few years without any attempt to place it in the framework of accepted theory concerning the manner of operation of economic forces in a market economy.” (Nicholas Kaldor, “How Monetarism Failed”, Challenge May/June 1985; e.a.)

Summarising Milton’s creed: “The central assertion of monetarism … is that an excessive increase in the supply of money, caused by the decisions of the note-issuing authority, the central bank, is the main, if not the sole, cause of inflation; that the cyclical fluctuations of the economy reflect the irregularities and aberrations with which the money supply is increased by the monetary authority, which is responsible also for distortions in the structure of production caused by imperfect anticipation of the delayed effects of increases in the money supply on prices… the only safe rule to follow is to secure a modest and stable rate of increase in the rate of growth of the money stock, which by itself will serve to stabilize the value of money and gradually eliminate cyclical instabilities.” (4)

Basic flaw in Friedman’s logic: the assumption that the money supply is “the source of the demand for goods and services.” (4) Instead “The demand for money, from the very beginning, was a reflection of the demand for commodities, and not the source of that demand” (5) In early money commodity (e.g., gold) society: “the value of the money commodity depended, in the longer run at least, on its costs of production, in the same way as the demand for other commodities” (5) Increased supply of gold, when it occurred, generally response to demand for gold as money: an endogenous event…

“the increase in the supply of money in circulation was a response to increased demand and not an autonomous event, though occasionally the supply of the money commodity ran ahead of the increase in the supply of other commodities, as with the gold and silver discovered in the new Spanish colonies of the sixteenth century; at such times, money could be said to have exerted an autonomous influence on the demand for goods and services… because those who first came into the possession of the new gold or silver … became the source of additional demand for goods and services. But the converse … was equally true—where the increase in the supply of the money commodity lagged behind, this placed obstacles on economic expansion that historically were gradually overcome with the successive introduction of money substitutes.” (5)

Contra Friedman, Kaldor argues credit does make a difference: “the main contention … of monetarism, that the money supply … is exogenously determined by the monetary authority … may be questioned from the start.” (6) “Monetarists … assume that the monetary authority determines the so-called "monetary base" … the amount of bank notes issued…” And that there are “either legally enforceable rules or conventions [that] determine an established ratio between this "base money" and all other forms of money. Hence the "monetary authority" ultimately determines the supply of money in all forms.” (6) and also…

“The further assumption that the (inverted) pyramid of bank money bears a stable relationship to the monetary base is supposed to be ensured by the banks' rationing credit so as to prevent their liabilities from becoming larger (or rising faster) than the legal or prudential reserve ratio permitted.” (6) Even these assumptions about supply are not enough… “the second and almost equally important credo is that the public's demand for money, as a proportion of income, is a stable one, not much influenced by changes of interest rates and other factors.” (7) Given these assumptions,

“any increase in the supply of money … will imply that the supply of money will exceed the demand at the prevailing level of incomes (people will "find themselves" with more money than they wish to hold). This defect, in their view, will be remedied… by an increase in expenditures that will raise [nominal] incomes sufficiently to eliminate the excess of supply over the demand for money.” (7) How does this theory stack up? “As a description of what happens in a modern economy, and as a piece of reasoning applied to situations where money consists of "credit money" brought about by the creation of public or private debt, this is a fallacious piece of reasoning.” (7) Results from inappropriate application of Quantity Theory of commodity-money to credit economy:

With commodity money “the total quantity in existence could be regarded as exogenously given at any one time”; and “where sudden and unexpected increases in supply could occur (such as those following the Spanish conquest of Mexico), the absorption of which necessitated a fall in the value of the money commodity relative to other commodities.” (7) But with credit money: “the same reasoning cannot be applied to cases where money was … simply a bookkeeping entry in the accounts of banks. The rules relevant to the creation of credit money are not of the same kind as those relevant to the production of gold or silver.” (7)

Credit money comes into existence, not as a result of mining but of the granting of bank credit to borrowers… The new credit first appears as an addition to the balances held by the borrowers. As the money is spent … the same addition will appear in the balances of the recipients… some part of the additional receipts will be saved, which may be reflected as an increase in savings deposits… To the extent that the second and third recipients, and so on, find that they have more than enough money in hand, they will apply the difference to the repayment of bank loans, and thereby extinguish the "excess supply" of money. Could we then suppose that the additional credit of £100 brings about an "excess supply" of money in an analogous manner to that created by the discovery of new gold? If the original borrower did not need £100 he would have borrowed less—say, £50—and left the remainder as an unutilized borrowing facility. If the subsequent recipients find that they have more money in hand than they need, it is they who ,will repay some of their bank loans. Again, the "excess money" is extinguished through loan repayment…

Thus “in the sense required by monetarist theory, an excess in the supply of money cannot come into existence; and if it did, it would automatically be extinguished through the repayment of bank indebtedness (or its equivalent), either by the original borrower or by others.” (8) So much for the theoretical failings; what about practice? “Improbable as it may sound, Friedman's extraordinary proposition was firmly believed in at the turn of the last decade in a number of important countries… Its outward expressions were the setting of "targets" for the increase in money supply … and … regarding the realization of these targets … as the first priority of policy… "monetarist" governments and central bankers managed to reduce the effective demand for goods and services considerably below their potential, which in turn may have caused a slowdown in the increase of the amount of money people wished to hold.” (10) However…

“experience soon demonstrated that the central bank has no direct control over the amount of its bank notes in circulation. The reason for this is that the bank cannot refuse payments to its own creditors by refusing to honor checks drawn on itself by the account-holders; nor, if it wishes to avoid major crises in the banking and financial system, can it close the "discount window," refusing to re-discount eligible bills on the ground that it is only willing to issue new money up to a certain daily maximum. Central banks are extremely sensitive to the danger of bank failures … central banks regard … the solvency of the banking system … as their most important function, taking precedence over economic objectives if these appear to be in conflict.” (10) As a result, monetary targetting in the UK was a failure:

“M3, which was planned to rise by 7-11 percent, had actually risen by 22 percent; both the money supply and the price level rose twice as fast under the new monetarist regime than they did under the five years of the previous Labour government. The cause of this was the new government's failure to recognize (in true monetarist fashion) that prices can rise on account of a rise in costs and not only the pressure of demand. Its first budget was deflationary in terms of the pressure of demand but strongly inflationary in its effects on prices, on account of the switch from direct to indirect taxation, the rise in mortgage rates, charges for school mews, etc.” (11; e.a.)

Inflation ultimately fell, not because of adaptive expectations, but because: “The level of import prices was greatly moderated by the rise in the exchange value of the pound, whilst North Sea oil … brought with it a large surplus on current account… [so that] by the end of the fourth year the government could claim to have succeeded in bringing down inflation from the 8.5 percent rate it inherited in May 1979 and the 22 percent attained in August 1980 (at the end of its first year in office) to 4 percent annually from mid-1983 to mid-1984. This latter result was largely due, however, to the rise in unemployment by 2 million (from 1 million to 3 million) and the consequential fall in the size of wage settlements, as well as to an accelerated rise in industrial productivity due to the closure and disappearance of the least efficient tail of industry.” (11)

“Over the period as a whole [mid-1979-mid-1984], total real consumption increased by 5 percent. But there was a 9.5 percent fall in the total number of employees and a 13 percent fall in the output of manufacturing industries. Gross investment in the manufacturing industries fell by 42 percent… This is a far worse record [for the UK] than that of the Great Depression of ” (11) Confirming Kaldor: ILO statistics UK Unemployed 1979: 1984:

ILO data confirms Monetarist period experienced initial increase in prices (& rise in unemployment) Insurance records show far worse picture for unemployment: from 5% in 1979 to 13% in 1984 Kaldor closes with Milton’s excuse for monetarism’s Paradise Lost: it’s the fault of the Central Banks!

“Friedman has admitted that as far as the United Kingdom is concerned, the money supply is not exogenously determined by the monetary authorities, but he attributed this to the "gross incompetence" of the Bank of England. Later he implied the same about his own country. However, this puts an entirely new complexion on monetarism. It was nowhere stated … that the quantity theory of money only holds in countries where the monetary authorities are sufficiently "competent" to regulate the money supply. If the Bank of England is so incompetent that it cannot do so, how can we be sure that … any of the central banks … are sufficiently competent to be able to treat their money supplies as exogenously determined? And what happens if they are not? Surely we need a general theory of money and prices that is capable of embracing the cases of countries with "incompetent" central banks, such as Britain and the United States…” (13)

Monetarism: The Sequel
Milton’s Monetarism superseded by “Rational Expectations” Not because RE better fitted evidence but Because RE more consistent with conventional doctrine Milton’s Monetarism implies inflation can have real effects Increased money supply causes increased demand/output until expectations adapt Continuous inflation could boost output… Rational Expectations implies conventional belief Nominal variables have no effect on real ones…

Consider standard explanation of NAIRU—outward movements of Phillips curve as expectations adapt Target Rate “Long run Phillips Curve” Inflation Accelerating inflation needed to sustain target Short run gain with long run pain... SRPC3 SRPC2 DMs causes some growth but… Expectations adapt SRPC1 Expected Inflation= DMs- DLab.Prod Expectations adapt Economy returns to pre-existing “natural” rate Unemployment Initial “natural” U rate with zero expected inflation

Model still suggests monetary factors can have real effects Increase MsLower U, Higher YFall back as expectations adaptIncrease Ms again…perennially lower U, higher Y Only way to eliminate monetaryreal causation is for agents to be able to predict the future Lucas put it best: “It is natural (to an economist) to view the cyclical correlation between real output and prices as arising from a volatile aggregate demand schedule that traces out a relatively stable, upward-sloping supply curve…” (Lucas, 1976, “Econometric Testing of the Natural Rate Hypothesis”, The Econometrics of Price Determination Conference, Board of Governors of the Federal Reserve System, October 30-31, 1970 Washington) Leaving aside this “natural” hypothesis, this poses a dilemma for a neoclassical…

“This point of departure leads to something of a paradox, since the absence of money illusion on the part of firms and consumers appears to imply a vertical aggregate supply schedule, which in turn implies that aggregate demand fluctuations of a purely nominal nature should lead to price fluctuations only The paradox may be resolved by the adoption of a refined view of the decision problem facing agents, in which short-run supply behavior under available information differs from long-run behavior under perfect information…” (51) This is adaptive expectations: agents don’t react to price changes that are thought to be temporary, but do to ones that are thought to be permanent. But for Lucas, this won’t do!:

“the standard hypothesis of “adaptive expectations” leads to an inadequate formulation of the natural rate hypothesis… “rational expectations,” originally proposed by Muth, … does lead to the natural rate hypothesis.” (51) So “rational expectations” preferred to adaptive Not because fits the empirical record; but Because it’s the only way to eliminate monetaryreal causation Essence of “rational” expectations is proposition that people have a model that lets them predict the future Keynes correct: essential fallacy of neoclassical economics concerns knowledge of the future Back to why “adaptive expectations” isn’t enough to rescue neoclassical vision of macroeconomics…

Lucas proposes typical adaptive expectations model: “letting yt be the log of real output in t, Pt be the log of the price level, and Pt* be the log of an index of expected future prices, one obtains an aggregate supply function:” (52) Aside: why logs? Because differential of log is % rate of change: Thus Or…

Then presume adaptive setting of price expectations Pt*: Logs implied here… Substitute into first equation: Variables “deviations from long term trend” Simplify to: Problem with this model from neoclassical point of view: It “promises unlimited real output gains from a well-chosen inflationary policy. Even a once-and-for-all price increase, … will induce increased output over the (infinity of) transition periods.” (53)

Adaptive expectations allows that: “inflation will yield higher real output on average only if price expectations fall below actual prices on average… adaptive expectation schemes … do not rule out this possibility of systematically biased expectations; hence they necessarily permit both short- and long-run Phillips-like trade-offs between inflation and real output…” (54) Only way to preserve real-monetary dichotomy is to replace adaptive expectations Delayed learning… With “rational expectations” Immediate prediction of future…

“the hypothesis of adaptive expectations was rejected as a component of the natural rate hypothesis on the grounds that, under some policy: E{Pt-P*} is non-zero. If the impossibility of a non-zero value for Expression 6 is taken as an essential feature of the natural rate theory, one is led simply to adding the assumption that Expression 6 is zero as an additional axiom or to assume that expectations are rational in the sense of Muth” (54) i.e., “rational expectations” is equivalent to assuming that people can predict the future!

From Keynes’s point of view, we go from “I accuse the classical economic theory of being itself one of these pretty, polite techniques “which tries to deal with the present by abstracting from the fact that we know very little about the future.” (1937: 215) To… which tries to deal with the present by pretending that we can predict the future.” (1937: 215) Back to Lucas’s model. Aggregate demand: yt: Log of real output Pt: Log of price level Xt: Log of nominal output

Rational Expectations : Back to the Future…
Lucas’s model leads nowhere (& has mathematical errors) Unimportant because this very “ad hoc” model later replaced by “representative agent” fiction Let’s start from birth of “rational” expectations Hypothesis began with Muth 1961: “Rational Expectations And The Theory Of Price Movements”, Econometrica, Vol. 29, No. 3 (July 1961) Obviously not the first to emphasise importance of expectations Keynes clearly did, but lost by Hicks IS-LM model Especially expectations under uncertainty “Rational” expectations gave form of expectations consistent with neoclassical theory—not reality! Muth gave vague empirical basis for hypothesis:

Rational Expectations : Back to the Future…
“Two major conclusions from studies of expectations data are the following: 1. Averages of expectations in an industry are more accurate than naive models and as accurate as elaborate equation systems, although there are considerable cross-sectional differences of opinion. 2. Reported expectations generally underestimate the extent of changes that actually take place.” Proposed that: “In order to explain these phenomena, I should like to suggest that expectations, since they are informed predictions of future events, are essentially the same as the predictions of the relevant economic theory.” (316)

Rational Expectations: Back to the Future…
Restates hypothesis as: “that expectations of firms (or, more generally, the subjective probability distribution of outcomes) tend to be distributed, for the same information set, about the prediction of the theory (or the “objective” probability distributions of outcomes).” Implicit in this that theory accurately predicts the future: “expectations … tend to be distributed … about the prediction of the theory … or the “objective” probability distributions of outcomes” These are the same thing??? No “hidden variable” problem? Muth assumes (neoclassical) theory accurately predicts future…

Justification for hypothesis also revealing: “The hypothesis asserts three things: (1) Information is scarce, and the economic system generally does not waste it...” (316) Say what??? If we’re talking neoclassical theory, shouldn’t this be: (1) Information is scarce, and therefore it is costly, & its marginal cost rises with “quantity”… Agents optimise: pay for information until marginal benefit equals marginal cost Therefore information less than perfect…”??? Starting premise is a scarce resource that is costless—contradiction of basic neoclassical theory!

Muth also makes “simplifying assumptions”: “In particular, we assume: 1. The random disturbances are normally distributed. 2. Certainty equivalents exist for the variables to be predicted. 3. The equations of the system, including the expectations formulas, are linear. These assumptions are not quite so strong as may appear at first because any one of them virtually implies the other two…” (317; e.a.) Makes linearity key feature of Ratex as practiced… Key limitation of neoclassical theory when dynamics introduced

Muth’s target in first Ratex paper was “cobweb theorem” Basic static supply & demand analysis: State (timeless) supply and demand formulae; Work out equilibrium Draw graph: Break for lunch… Problem: agricultural markets not this stable…

Attempted dynamic explanation: cobweb model… Recast supply and demand as time-lagged (actually time-delayed) functions: Demand now reflects prices now Supply now reflects prices last season Farmers plant based on last year’s returns: Adaptive expectations Basic formulae: Producers expect next season’s price to be same as last season’s; or… Yields difference equation for prices: Producers plant this season’s crop based on last season’s price Gives same equilibrium result as static formula

Set Pt=Pt-1=P: So eventual outcome same as statics? “Statics is long-run dynamics?” Depends on values of parameters…

For values of slope parameters bs/bd<1, “dynamic=static” But for bs/bd>1, “dynamic instability”

No convergence to equilibrium price; “Crazy” prices result: negative, tending to +/- infinity… Randomness doesn’t help… System still tends to impossible prices

Results counter-intuitive: Instability results if suppliers more price responsive than consumers Which is the case But implies insane instability Which isn’t the case Volatility, yes; negative prices, no! Neoclassical reaction: Dynamics useless; or Expectations rational: stability results from forward-looking, informed expectations But there is another reaction…

Markets (and models of markets) cannot be linear Crazy results (negative prices & quantities) product of linear form for demand & supply curves Given Dt=ad-bdPt, feed in high Pt, you’ll get negative Dt But even neoclassical theory doesn’t justify linear demand & supply curves “Non-satiation” implies D as P0 Ditto supply: stops at 0, reaches finite maximum as marginal cost Nonlinear, time-delayed models give realistic cycles—no need to hypothesise “rational” expectations to tame the cobweb…

Expectations: Back to the Reality…
Compare linear to nonlinear Simple nonlinear demand/supply curves Modified rectangular hyperbolas Basic hyperbola y=1/x Area under hyperbola crucial to definition of log, exponential; Used for illustration purposes only here… Generalised hyperbola formula is Used to derive S & D curves:

Nonlinear demand: Nonlinear supply: Graphing them: More realistic even in terms of neoclassical theory than standard “linear” curves used Linear obsession mainly due to lazy pedagogy But has real impact on development of theory

Solving for P as a function of time with these curves: Generates sustained cycles: More “interesting” deterministic dynamics possible with more complex functions Chaos can arise Impact of noise instructive:

Any pattern at all can result, without breakdown:

Apparent “volatility clustering”, cycles… Very difficult to get from linear models “Looks like” empirical data too, even though model incredibly simple: “Missing ingredient” in dynamic models may not have been “rational” expectations but nonlinearity

Expectations: Back to the Future…
So Muth’s solution to cobweb dilemma not the necessary nor only solution… Back to Muth’s model Starts with cobweb model stated as deviations from equilibrium: pet is expectation of price to apply in period t Differs from previous “adaptive expectations” formula mt is random shock term with assumed mean zero, no serial correlation… Combines equations to yield

Derives prediction (expected price) by setting expected value of mt equal to mean of zero. Then: “Rational” expectations then implies that: “pet=0, or that the expected price equals the equilibrium price. As long as the disturbances occur only in the supply function, price and quantity movements from one period to the next would be entirely along the demand curve.” (318) In contrast to conventional linear cobweb Bounce from supply to demand to supply… And nonlinear cobweb shown earlier Muth next considers predictable shocks…

Concept of predictable shocks becomes essence of Lucas/Sargent macroeconomic application of Ratex “Natural rate” assumes Real economy always in long run equilibrium Relative prices set by real factors—technology & tastes All inflation caused by monetary growth Money supply totally under government control No endogenous money (or credit-creation completely constrained by government policy) “Rational” agents can then predict that increase in money supply will cause inflation Optimising actions of agents pass predictable monetary shock through to prices with no impact on real variables (output, employment, etc.)

Given predictable shocks, expected price (i.e., expected deviation from equilibrium price) a function of expected value of shocks Start from same reduced form equation for pt: But now E(mt) not zero    Rest of Muth’s critique of “adaptive expectations” cobweb models relatively unimportant Real importance of paper is argument for legitimacy of “rational” expectations…

The Sorry History of Macroeconomics II

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