chapters in economic policy part i unit 4 from the monetarism to the new keynesian economics
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CHAPTERS IN ECONOMIC POLICY Part. I Unit 4 From the Monetarism to the “New Keynesian Economics”.

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Milton Friedman (19122006) was one of the most influential economists and political commentators of the XX century. In the 1960s and early 1970s he led the monetarist criticism against the Keynesian orthodoxy

Friedman’s early contributions:

Essays in Positive Economics, 1953 (a plea for a positivist approach in economics)

A Theory of the Consumption Function, 1957 (on the “Permanent Income Hypothesis” of consumption)

Friedman\'s criticisms of Keynesian theory began in 1956 with his “restatement” of the quantity theory of money (M. Friedman (1956), “The Quantity Theory of Money: A Restatement” in Studies in the Quantity Theory of Money ed. by M. Friedman)

In this work Friedman maintained that he demand for money:

i) was highly stable;

ii) it could not be regarded as infinitely elastic at some low interest rate (F. denies the “liquidity trap”)

More generally, Friedman and the monetarists maintained, contrary to Keynes, that in the medium-long run the economic systems tend to reach full employment equilibrium (Yn)  provided that governments do not try to interfere

According to the monetarists, full employment does not mean that in equilibrium u=0

In Friedman’s view, the unemployment rate could not be sustained below a certain level, a level that he called the “natural rate of unemployment”

Furthermore, in his analysis of inflation and of the effects of monetary and fiscal policies, Friedman maintained that a key role was played by expectations

Adaptive Expectation Hypothesis (AEH) (Friedman): for any given period, people’s expectations are modified by an amount which is proportional to the past errors:

Pet = Pet-1 + λ (Pt-1 Pet-1)

Limits of this hypothesis: It ignores the fact that economic agents take into account more information than simply the past behaviour of the variable

During the 1960s the debates between the keynesians and the monetarists centered around three main issues:

1) the Phillips curve

2) the effectiveness of monetary policy versus fiscal policy

3) the role of economic policy in the short run

1) the Phillips curve

According to Friedman, the original Phillips curve did not take into account the fact that people’s expectations on future inflation play a key role in the wage determination process

By including expectations the Phillips curve equation becomes:

πt = πet α ut

Friedman denied therefore any stable trade-off between the rate of unemployment and the rate of inflation

In any case, the unemployment rate could not be sustained below the “natural rate of unemployment

During the 70’s, contrary to the predictions of the original Phillips curve, the U.S. and the OECD countries were affected by both high inflation and high unemployment (stagflation). This was perceived as a major setback to the Keynesian model

The Phillips curve equation becomes:

πt = πet+( + z)  α ut

2) the effectiveness of monetary policy versus fiscal policy

Friedman challenged the view that fiscal policy could affect output faster and more reliably than monetary policy

In A Monetary History of the United States, 1867-1960, published in 1963, Friedman and Anna Schwartz reviewed the history of US monetary policy and came to the conclusion that monetary policy was not only very powerful but that changes in the money stock also explained most of the fluctuations in output

They interpreted the Great Depression as the result of major mistake in monetary policy.

3) the role of economic policy in the short run

Friedman was skeptical that economists knew enough to stabilize output, and that policy makers could be trusted to do the right thing

He therefore argued for the use of simple rules, such as steady money growth. In his view, political pressures to “do something” in the face of relatively mild problems did more harm than good

The New Classical Economics and the Rational Expectations Critique

In the early 1970s, Robert Lucas, Thomas Sargent, and Robert Barro (the intellectual leaders of the so called “New Classical Economics”) led a strong attack against the mainstream Keynesian macroeconomics

They argued that the predictions of Keynesian macroeconomics were incorrect, and based on a doctrine that was fundamentally flawed

The “New Classicals”:

i) aimed to derive the aggregative behaviour of the economy from the basic principles of rational maxi- mizing firms and individuals (“microfoundations of macroeconomics”)

ii) maintained that “rational expectations” played a central role in explaining the dynamics of the economic systems

According to Lucas and Sargent, Keynesian economics had ignored, in assessing the effectiveness of monetary and fiscal policies, the full implications of agents’ expectations

However, the NCE also criticized Friedman’s adaptive expectations hypothesis because this implied a “backward looking” behaviour by the individuals

In Lucas and Sargent’s view, on the contrary, individuals are “forward looking” (Rational Expectations Hypothesis)

Rational Expectations Hypothesis (REH): individuals when making decisions use all relevant information, including knowledge of the structure of the economic system

Although the future is not fully predictable, agents\' expectations are assumed not to be systematically biased.

Outcomes that are being forecasted do not differ systematically from the market equilibrium results

Thinking of people as having rational expectations had major implications, all highly damaging to Keynesian macroeconomics

Policy Ineffectiveness Proposition (Sargent): If the Fed attempts to reduce inflation through an expansionary monetary policy, the economic agents will anticipate the effects of this change of policy and raise their inflationary expectations accordingly (according to the NCE only unanticipated changes in money affect output)

Disinflation policies: According to the macro models based on adaptive expectations, disinflation—a decrease in inflation—can be obtained only at the cost of higher unemployment:

πtπt-1 = α (ut un)

According to Lucas and Sargent, on the contrary, it is unrealistic to assume that wage setters would not consider changes in policy when forming their expectations

If wage setters can be convinced that inflation is indeed going to be lower than in the past, they decrease immediately their expectations of inflation, which would in turn reduce actual inflation, without the need for a change in the unemployment rate

The essential ingredient of successful disinflation, according to the New Classical Economists, is credibility of monetary policy—the belief by wage setters that the central bank is truly committed to reducing inflation
The New Keynesian Economics

The “new Keynesians” are a group of researchers working on the macroeconomic implications of imperfections in different markets (e.g. imperfect information and incomplete markets)

According to the “new Keynesians” such phenomena as the persistence of unemployment and credit rationing are inconsistent with the standard microeconomic theory

Contrary to the NCE, the New Keynesians maintain therefore that microeconomic theory should be adapted in order to tackle macroeconomic problems

Some topics:

Efficiency wage models: are based on the hypotheses that: i) there is imperfect information about the characteristics of the workers; ii) the actions of the workers cannot be adequately monitored

It can be demonstrated that the quality of the labour force and its productivity increases (and conversely labour turnover decreases) with an increase in the wage

In other words, the wage that maximizes the firm’s profits need not to fall to market clearing levels

Credit rationing

Credit rationing is a situation in which the suppliers of capital (lenders) do not raise interest rates in the presence of an excess demand for capital

Reason: increasing interest rates may lower the expected return to the supplier of capital, either because an adverse selection effect (the mix of applicants changes adversely) or because a moralhazard effect (borrowers are induced to take riskier actions)

Nominal rigidities

Stanley Fischer and John Taylor emphasized the presence of nominal rigidities, or the fact that many wages and prices cannot be immediately readjusted when there is a change in policy (as a consequence of medium-long term contracts)

Contrary to Lucas analysis of disinflation, therefore, a rapid disinflation would cause an increase in unemployment even if the rational expectations hypothesis applies

Common beliefs:

Most macroeconomists agree that:

-In the short run, shifts in aggregate demand affect output

-In the medium run, output returns to the natural level

-In the long run, capital accumulation and the rate of technological progress are the main factors that determine the evolution of the level of output

-Monetary policy affects output in the short run, but not in the medium run or the long run

-Fiscal policy has short-run, medium-run, and long-run effects on output

Some of the disagreements involve:

The length of the “short run,” the period of time over which aggregate demand affects output

The role of policy: those who believe that output returns quickly to the natural level advocate the use of tight rules on both fiscal and monetary policy. Those who believe that the adjustment is slow prefer more flexible stabilization policies