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Milton Friedman and the Chicago School of Economics

Milton Friedman and the Chicago School of Economics. Background Monetarism The Chicago School Milton Friedman A Biography Friedman’s main ideas Robert Lucas Gary Stanley Becker. Background . Old School vs. New School Tenets: Optimizing behavior

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Milton Friedman and the Chicago School of Economics

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  1. Milton Friedman and theChicago School of Economics

  2. Background • Monetarism • The Chicago School • Milton Friedman • A Biography • Friedman’smainideas • Robert Lucas • Gary Stanley Becker

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

  4. Monetarism • The term "Monetarism" was coined in 1968 by Karl Brunnerto refer to the macroeconomic theories and doctrines most closely associated with University of Chicago economist Milton Friedman. • Although "born" in 1956, Monetarism only became a powerful intellectual force in the late 1960s and early 1970s, and had to wait until the late 1970s and early 1980s to be channeled into economic policy. By the mid-1980s, however, Monetarism was largely a spent force and, today, one would have to search very far indeed to find an old-fashioned "Monetarist".

  5. THE MONETARIST REVOLUTION • By the late 1940s, the Keynesian school was strong in the USA, where most of macroeconomic research was conducted • The University of Chicago (“Chicago School”) led against the Keynesians an intellectual attack • The success of the Chicago School is due to MILTON FRIEDMAN: extraordinary intellectual vigor, leadership charisma, government experience, communication skills • He assembled a group of young economists: “Workshop in Money and Banking” • He devoted much time and effort to popularize his ideas

  6. The Chicago School of Economic Thought • “It describes a neoclassical school ofthought within the academic communityof economists, with a strong focus aroundthe faculty of University of Chicago.” • The main players were Frank Knight, Friedrichvon Hayek, Ronald Coase, George Stigler,Milton Friedman, Robert Fogel, Gary Becker,Richard Posner, Robert Lucas, and EugeneFama. • This Spread To Economics Depts. Everywhere

  7. The Chicago School • Theodore Schultz arrives 1943, chair 1946-61. Nobel Prize, 1979. • Milton Friedman arrives 1946. Nobel Prize in 1976. • Von Hayek (1950-62). Nobel Prize, 1974. • George Stigler arrives 1958. Nobel Prize, 1982. • Ronald Coast arrives 1964. Nobel, 1991. • Gary Becker earned PhD at Chicago, returns to faculty in 1970. Nobel Prize, 1992. • Robert Lucas earned his degrees at Chicago, returned in 1974 as professor. Nobel Prize, 1995.

  8. Chicago School: Basic Tenets • Markets are a good way to organizevoluntary and beneficial exchanges. • Government serves more as “umpire”than as socialist organizer of economy. • Economic power serves as a check and acounter to political power (e.g. USAcontrasted with Chavez’ Venezuela).

  9. PrescientQuate for Venezuela • It is a mark of the political freedom in acapitalist society that people can openlyadvocate and work for socialism. • How could the freedom to advocatecapitalism be preserved and protected ina socialist society? • Source: Friedman, Capitalism and Freedom, 1962

  10. Markets and MinoritiesRights. • The preservation of Jews through the Middle Ages waspossible because of the existence of a market sector inwhich they could operate and maintain themselvesdespite persecution. • Yet paradoxically enough, the enemies of the free market –the Socialists and Communists – have been recruited indisproportionate measure from minority groups. • Source: Friedman, Capitalism and Freedom, 1962

  11. Chicago School: Advice • On Government • “Stimulus” Packages:…plan tax rates so as to provide sufficient revenues tocover planned expenditures on the average of one yearwith another, again without regard to year-to-yearchanges in economic stability. • Hence, he would have opposed the recentFederal “Stimulus Packages” • Source: Friedman, Capitalism and Freedom, 1962

  12. Chicago School: Advice • On Education Funding • Governments should require a minimum level ofschooling financed by giving parents vouchersredeemable for a specified maximum sum perchild per year if spent on “approved”educational services….like the GI Bill. • Source: Friedman, Capitalism and Freedom, 1962

  13. Chicago School: Advice • Monopolies Are Bad, Even Governmental • The historical reason why we have a Post Office monopolyis because the Pony Express did such a good job ofcarrying mail across the continent that, when thegovernment introduced transcontinental service, itcouldn’t compete effectively and lost money. • Source: Friedman, Capitalism and Freedom, 1962

  14. Chicago School: Advice • On Social Security • What conceivable justification is there for taxingthe young to subsidize the old regardless of theeconomic status of the old….It is doubtful thatthe taxes paid have sufficed to finance theaccumulated obligation. • Source: Friedman, Capitalism and Freedom, 1962

  15. Chicago School: Advice • On Government Anti-Poverty Policy • The program, that is, should be designed to help people aspeople, not as members of particular occupationalgroups or age groups or wage-rate groups or labororganizations or industries… • The arrangement that recommends itself on purelymechanical grounds is a negative income tax. • Source: Friedman, Capitalism and Freedom, 1962 • Eventually, this was implemented as the“Earned Income Tax Credit”

  16. A PartingThought • There is still a tendency to regard any existinggovernment intervention as desirable, toattribute all evils to the market, and to evaluateproposals for government control in their idealform, as they might work if run by able,disinterested men, free from the pressure ofspecial interest groups. The proponents oflimited government and free enterprise are stillon the defensive. • Source: Friedman, Capitalism and Freedom, 1962

  17. Milton Friedman

  18. Milton and Rose Friedman

  19. Milton Friedman – A ShortBiography • Milton Friedman (1912--2006) was bornin Brooklyn, New York • Friedman met his wife, Rose Director(1910(1)--2009), while a graduate studentat the University of Chicago • They were married in 1938 • They had two children

  20. Friedman’s Education: • B.A. (1932) Rutgers University • M.A. (1933) University of Chicago • Ph.D. (1946) Columbia University • Faculty at the University of Chicago from1946 to 1976. • He also held positions at various otherinstitutions (NBER, University of Wisconsin,University of Minnesota, Cambridge,Columbia, Stanford, etc…)

  21. Much of Friedman’sworkfocused on statistics. • He was a brilliant statistician. • Friedman developed sequential sampling for statistics. • 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 1948.

  22. PrestigiousAwards • Friedman was awarded The SverigesRiksbank Prize in Economic Sciences inMemory of Alfred Nobel in1976 • “for his achievements in the fields of consumptionanalysis, monetary history and theory, and for hisdemonstration of the complexity of stabilizationpolicy.” • Friedman was awarded • The John Bates Clark Award (1951) • The National Medal of Science (1988) • The Presidential Medal of Freedom (1988)

  23. Friedman spent his professorial career at the University of Chicago. • He won the Nobel Prize in Economics in 1976. • He was a key player in the Chicago Shoolof Economics.

  24. Milton Friedman • ·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.”

  25. Friedman did not have a glided pedigree or a global presence. • He worked in think tanks and in govermant job.

  26. Friedman’s Intellectual Legacy • Friedman is mainly associated with twoschools of thought: 1. The Chicago School of Economics 2. Monetarism

  27. Friedman worked on the permanent income hypothesis and studied far-sighted expectations. • Friedman explained the difference between annual income and „permanent” incom. • He found that current consumtion also depended on expectations of future income. • Friedman believed that would spend extra income on an investment good, such as a car or a major appliance.

  28. Friedman studiedincome and consuptionpatternsover time and over a cross-section of thepopulation. • He found that as income rose over time, ninety percent of income went to consumption. • In cross-section analysis, Friedman found that poor families spent a larger percentage of their incomes that rich people did. • Friedman concluded that people looked ahead in life to determine spending patterns, and therefore consumption patterns depended on expectations of income.

  29. Thisstudyhadharshimplications for Keynesianthought, theories of expectatins, and themathodologyof economics. • Friedman’s work brought Keynesian assumptions into question by showing that the economy was working more smoothly than Keynes had expected. • Theories of rational expectations were developed. • The consumption study changed the methodology of economics. • Friedman combined theoretical underpinnings with his empirical background.

  30. Friedman changedhowtheeconomicprofessionregardedmoneymatters. • Despite the importance of balancing the money supply, economists did not think much about money. • Economists saw money as tool to help goods and services circulate better in the economy. • This was evident in Keynesian economic goverment policies.

  31. Friedman set out to write a completemonetaryhistory. • He did this at a time when others thought it was useless. • This was modern social science research at its finest.

  32. Monetarism • Friedman’s ideas about monetary policyand inflation have altered the conduct ofmonetary policy. • The Federal Reserve Bank (“The Fed”) isin charge of the nation’s monetary policy. • Not surprisingly, Friedman was a critic ofThe Fed.

  33. THE MONETARIST REVOLUTION - Friedman’s main ideas 1. A strong defender of free markets. He actively promoted the view that governments are a threat to freedom, and not just in economic matters. 2. He confronted Keynes’s view that fiscal policy is a useful tool for macroeconomic stabilization and that monetary policy is useless - MONETARIST “A Monetary History of the United States, 1867-1960” - it fundamentally changed the way we look at monetary policy - at empirical level, it attributes the Great Depression to bad monetary policies (Keynes blamed procyclical fiscal policies)

  34. THE MONETARIST REVOLUTION - Friedman’s main ideas 3. A study of consumption patterns in the USA: “A Theory of the Consumption Function” (1956) - he argued that Keynes consumption function had little theoretical foundation and questionable empirical validity - he put forward the permanent income hypothesis - he weakened the significance of the Keynesian multiplier and the view that fiscal policy can be a tool for output stabilization 4. Friedman explained why the Phillips curve would vanish as soon as the authorities attempted to exploit the output-inflation trade-off

  35. THE MONETARIST REVOLUTION - Friedman’s main ideas - He restored the importance of expectations(the expectations-augmented Phillips curve) and he invented the long-run vertical aggregate supply schedule In general, Europe was slow to recognize the power of the monetarists’ attack and did not contribute much to the research effort. UK was dominated by Keynesians, until Mrs. Thatcher was elected and she brought in Friedman as an advisor. The Chicago school also contributed much to our understanding of the open economies; much of Mundell’s work was produced when he was in Chicago (the “monetary approach to the exchange rate”)

  36. To the lay public, Milton Friedman is best known for his political views. • Its well-known features are captured succinctly in his words: "The basic long-run objectives, shared, I am sure by most economists, are political freedom, economic efficiency and substantial equality of economic power...I believe - and at this stage agreement will be far less widespread - that all three objectives can best be realized by relying, as far as possible, on a market mechanism within a "competitive order" to organize the utilization of economic resources." (M. Friedman, 1948)

  37. Monetarism Friedman on Inflation: • “Inflation is always and everywhere a monetaryphenomenon in the sense that it is and can beproduced only by a more rapid increase in thequantity of money than in output” • The Counter-Revolution in Monetary Theory (1970) • The tradeoff between unemployment and inflation(the Phillips Curve) is not stable. It is possible tohave both high inflation and high unemployment(Stagflation). • Friedman’s warnings were confirmedduring the 1970s stagflation, wrought byJimmy Carter’s Fed Chairman!!!!

  38. From his monetaryhistory, Friedman developedthequantitytheory of money. • He found additional money led either to economic growth, inflation, or a change in people’s consumption patterns. • This summary became known as the quantity theory of money. • From his historical research, Friedmanfound that money affected the economy in four ways.

  39. Friedman arguedthatincompetentmonetarypolicycausedthe Great Depression. • He saw the Great Depression as a great contraction. • He argued that the FederalReserve was unwilling to act.

  40. Friedman’smonetaryhistoryaffectedmonetarypolicy. • Friedman found that money was a useful social convention. • He believed that money worked mechanistically. • He found that money policy could prevent money from causing economic problems. • Friedman argued that the FederalReserve should expand to money supply at a steady rate over time.

  41. Friedman’sideashadimplications for theunemployment-inflationtradeoff. • Friedman argued that the level of unemployment was dermined by many different factors. • He believed that the economy would move to this natural level of unemployment. • Undestanding that the economy would move to dis natural level of unemployment, friedman argued that the country needed to decide if it wanted high inflation or low inflation when this happened. • He said there would be a given amount of unemployment, unless the goverment got out of the way.

  42. Friedman brought market-oriented thinking and economic freedom into public discourse. • Overall, economic freedom and the way markets work have an important value.

  43. Already in Friedman’s early years, long before Monetarism became formulated as a distinct economic approach, Friedman had already formed his basic "vision" of macroeconomics and the role of government policy, a vision made famous later in his popular tracts such as Capitalism and Freedom (1962) and Free to Choose (1980, with Rose Friedman) and numerous newspaper and magazine columns, interviews, television shows, etc.

  44. The Great Contraction • Friedman’s most ambitious work is: • A Monetary History of the United States, 18671960 with Anna Schwartz. Princeton UniversityPress, 1963. • Friedman and Schwartz argued that the GreatDepression was prolonged and perhaps causedby the Federal Reserve Bank. • The FED did not supply enough money, and themonetary contraction helped turned therecession into the Great Depression.

  45. In conclusion, therearefourstrands of contemporaryissues and concepts. • Economists agree on may importent economic issues and concepts. • The market socialism debate looks at how markets will work. • The debate technology and entrepreneurialism, and how they affect the cycles of the conomy and long-run growth, continues todey. • The legacy of keynes is evident in contemporary discussions od why the macroeconomic economy might be unstable, how investment might not measure up to demand, and why the labor markets might not adjust well. • The New Classicals argued that the macroeconomic economy is fairly stable, that markets work fairly well, and that they work better when the government does nirinttervene.

  46. Therearenumerousexamples of friedman’sideasintoday’sdiscourse. • He believed that the system of fixed exchange rates would not work. • In 1952 he argued for an all-volunteer army, which was later adapted. • He argued for school vouchers in 1962. • He proposed both replacing welfare with cash payments and instituting a negative income tax. • He supported a flat-rate income tax. • He proposed that government should cease printing money. • Friedman opposed social security because the thought that people took it for granted.

  47. Robert Lucas • Born in Yakima, Washington, 1937. • Influenced by one of his teachers—Milton Friedman—and Samuelson’s Foundations. • BA, History. PhD, Economics, Chicago. • Professor at Carnegie-Mellon, 1970. • Professor at University of Chicago, 1974. • Editor of Journal of Political Economy since 1978.

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

  49. THE RATIONAL EXPECTATIONS REVOLUTION • Another attack on Keynesian economics: the rational expectations revolution • The expectations-augmented Philips curve of Friedman had left an important question unanswered: what drives expectations? • Most economists: expectations are gradually catching up with actually observed inflation (adaptive expectations) • A major step: Robert E.Lucas Jr. (Nobel prize laureate), a student of Friedman, led the rational expectations revolution • They noted that: if the forward-looking component dominates and if expectations are not systematically biased, the Phillips curve is always vertical and systematic policy does not work

  50. THE RATIONAL EXPECTATIONS REVOLUTION • Their conclusion: monetary policy only affects output and employment if and only if it creates inflation surprises • The RE revolution’s message: macroeconomic policies should not be used on and off with complete discretion. Policy should obey rules and aim at establishing credibility by sticking to these rules.

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