CHAPTERS IN ECONOMIC POLICY Part. I Unit 4 From the Monetarism to the

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CHAPTERS IN ECONOMIC POLICY Part. IUnit 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
• Friedmans 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)

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• 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)

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• 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 u0
• In Friedmans view, the unemployment rate could
  not be sustained below a certain level, a level
  that he called the natural rate of unemployment

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• 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, peoples expectations are
  modified by an amount which is proportional to
  the past errors
• Pet Pet-1 ? (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

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• 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

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• 1) the Phillips curve
• According to Friedman, the original Phillips
  curve did not take into account the fact that
  peoples expectations on future inflation play a
  key role in the wage determination process
• By including expectations the Phillips curve
  equation becomes
• pt pet ? a ut

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• 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

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• During the 70s, 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
• pt pet (? z) ? a ut

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• 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.

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• 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

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• 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

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• 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

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• However, the NCE also criticized Friedmans
  adaptive expectations hypothesis because this
  implied a backward looking behaviour by the
  individuals
• In Lucas and Sargents view, on the contrary,
  individuals are forward looking (Rational
  Expectations Hypothesis)

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• 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

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• 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)

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• Disinflation policies According to the macro
  models based on adaptive expectations,
  disinflationa decrease in inflationcan be
  obtained only at the cost of higher unemployment
• pt ? pt-1 ? a (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

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

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• 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

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• 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
  firms profits need not to fall to market
  clearing levels

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• 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 moral hazard effect (borrowers are induced to
  take riskier actions)

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• 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

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• 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

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• 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

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