The Sorry History of Macroeconomics II

1
The Sorry History of Macroeconomics II

• Steve Keen

2
The Phillips Curve

• Given a priori expectation that nonlinear
  factor-priceprice inflation relationship
  should exist, Phillips went looking for it in
  data
• Collated seven separate series to form base
  1861-1913 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

3
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

4
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. 283-4
• Overall cost-based perspective on prices
• Only 1st of 3 causal factors shown in curve
• Other factors discussed verbally but not
  incorporated in regression

5
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

6
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 lt 100 data
  points
• Such calculations not possible without computers

7
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

• Data itself not shown in paper (except for most
  recent decade 1947-57)
• only visually compelling graphs

8
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 1947-1957
• but his essay was powerful because of its visual
  impact the data appeared to be magnetically
  attracted to the curve. (Leeson emphasis added)

9
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
10
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
11
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
12
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.

13
The Phillips Curve

• Lets test impact of Phillipss curve on dynamic
  model
• replace invented linear relation in previous
  model
• with nonlinear (exponential regression) on data

• You can almost see the curve

14
The Phillips Curve

• Nonlinear regression has reasonable correlation

15
The Phillips Curve

• Put into model and (with some tweaks to
  parameters)

• This ( Phillipss original models) far removed
  from standard economics comparative statics

16
The Phillips Curve

• Phillipss colleague R.G.D. Allen wrote
• Until the engineers 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)

17
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

18
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)

Vietnamwar
OPEC II
BoomYears
19
The Phillips Curve Breakdown?

• 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.)

20
The Phillips Curve Breakdown?

• Lets consider whether Phillipss (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

21
The Phillips Curve Breakdown?

• Plot residuals against 1-dimensional Phillips
  curve

• Derive change in unemployment plot against
  residuals of 1D regression

22
The Phillips Curve Breakdown?

• Expected negative relationship vaguely visible
• Rising U?Falling Wages
• Not much of a relationship, but lets proceed

23
The Phillips Curve Breakdown?

• 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?

24
The Phillips Curve Breakdown?

• A lot!

• And not just on system stability

25
The Phillips Curve Breakdown?

• 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.

26
The Phillips Curve Breakdown?

• Phillips Curve doesnt look so broken down
  any more

• Didnt break down
• was assassinated
• Economists in general didnt comprehend
  Phillipss dynamics
• Neoclassicals used apparent breakdown to reassert
  money neutrality

27
The Phillips Curve Breakdown?

• Generalised Phillips curve easily copes with (U,
  dW) combinations like
• U5, dW-3.5 and
• U5, dW6
• 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)
• Phillipss conclusion thus still in general
  justified

28
The Phillips Curve Breakdown?

• 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

29
The Phillips Curve Breakdown?

• 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.)

30
The Phillips Curve Breakdown?

• Apparent breakdown of relationship in late
  60s-70s assisted rise of Monetarist economics
• First phase Friedmans 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 pointassumed nature of money

31
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???

32
Monetarism The Movie

• Key aspect of Miltons assumed Paradise
• No debt-based money
• Money created by non-economic entity (ultimately
  government)
• Models domain (see HET Methodology lecture)
  therefore world without credit money, fractional
  banking
• Is that our world?
• Not nowand probably never!
• Consider ratio of debt to M1 (Fiat
  moneycurrencyroughly 40 of M1) in USA

33
Monetarism The Movie

• Even in 1975, DebtM1 ratio almost 6 to 1
• Now over 141 DebtCurrency ratio about 501!

34
Monetarism The Movie

• Miltons 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 suffersreal
  value of money holdings rises for all agents
• In credit money world, debtors suffer
• Real burden of debt increases Fishers Debt
  Deflation Hypothesis
• Model irrelevant to credit money real world

35
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

36
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)

37
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 years
  income, or about 5.2 weeks income. That is,
  desired velocity is about ten per year. (4)
• Remember Hickss typical classical theory
  MDk.I?
• Keyness precautionary, speculative and finance
  motives for money out the window
• Next, what happens if quantity of money
  increased?...
• Start with nominal Y10,000 M1,000

38
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 Miltons Paradise

39
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

40
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 mans expenditure is
  another mans receipt (5)
• Spending by each individual drives up prices
• Peoples 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?

41
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

42
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 years proceeds
  from the sale of services in cash balances, ie.,
  4 instead of 5.2 weeks income. (11)
• Which causes further inflation

43
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
  years 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

44
Monetarism The Movie

• When prices are stable, one component of the
  cost is zeronamely, the annual costbut the
  other component is notnamely, 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

45
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)

46
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. 18-19)
• Anticipated rate of price change P
• The productive services rendered per year by a
  dollar of cash balances as factor of production
  MPM
• The nonpecuniary 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

47
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 Miltons Paradise, IRD0 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)

48
Monetarism The Movie

• We finally have a market measure of the internal
  rate of discountthat 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 rB0 then optimal rate of price
  deflation should equal return on equities
• Under the assumptions that

49
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)
• Were still in Paradise thenno uncertainty
• What about credit money?
• Money in the form of demand deposits adds no
  special complexity. (37)
• What about growth?

50
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.

51
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)

52
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)

53
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)
• Miltons Monetarism adopted by Thatchers UK,
  Reagans USA in mid-70s.
• USA application clouded by huge government
  deficits
• UK clearest example of actual impact
• Kaldor put it best

54
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
  decadeparticularly by President Reagan's
  administration in the United States and Mrs.
  Thatcher's in Great Britainwill, 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.)

55
Monetarism The Reality Show

• Summarising Miltons 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)

56
Monetarism The Reality Show

• Basic flaw in Friedmans 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

57
Monetarism The Reality Show

• 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 truewhere 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)

58
Monetarism The Reality Show

• 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

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Monetarism The Reality Show

• 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,

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Monetarism The Reality Show

• 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

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Monetarism The Reality Show

• 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)

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Monetarism The Reality Show

• 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 lesssay, 50and 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

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Monetarism The Reality Show

• 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

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Monetarism The Reality Show

• 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

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Monetarism The Reality Show

• 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.)

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Monetarism The Reality Show

• 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)

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Monetarism The Reality Show

• 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 1929-32. (11)
• Confirming Kaldor ILO statistics UK Unemployed
• 1979 1295.7
• 1984 3159.8

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Monetarism The Reality Show

• 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 Miltons excuse for
  monetarisms Paradise Lost its the fault of the
  Central Banks!

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Monetarism The Reality Show

• 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)

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Monetarism The Sequel

• Miltons Monetarism superseded by Rational
  Expectations
• Not because RE better fitted evidence but
• Because RE more consistent with conventional
  doctrine
• Miltons 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

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Monetarism The Sequel

• Consider standard explanation of NAIRUoutward
  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...
DMs causes some growth but
Expectations adapt
Expected Inflation DMs- DLab.Prod
Expectations adapt
Economy returns to pre-existing natural rate
Unemployment
Initial natural U rate with zero expected
inflation
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Monetarism The Sequel

• 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

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Monetarism The Sequel

• 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 dont react
  to price changes that are thought to be
  temporary, but do to ones that are thought to be
  permanent.
• But for Lucas, this wont do!

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Monetarism The Sequel

• 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 its 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 isnt enough
  to rescue neoclassical vision of macroeconomics

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Monetarism The Sequel

• 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
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Monetarism The Sequel

• 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)

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Monetarism The Sequel

• 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

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Monetarism The Sequel

• the hypothesis of adaptive expectations was
  rejected as a component of the natural rate
  hypothesis on the grounds that, under some
  policy
• EPt-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!

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Monetarism The Sequel

• From Keyness 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 Lucass model. Aggregate demand

• yt Log of real output
• Pt Log of price level
• Xt Log of nominal output

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Rational Expectations Back to the Future

• Lucass model leads nowhere ( has mathematical
  errors)
• Unimportant because this very ad hoc model
  later replaced by representative agent fiction
• Lets 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 theorynot reality!
• Muth gave vague empirical basis for hypothesis

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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)

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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

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Rational Expectations Back to the 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 were talking neoclassical theory, shouldnt
  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
  costlesscontradiction of basic neoclassical
  theory!

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Rational Expectations Back to the Future

• 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

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Rational Expectations Back to the Future

• Muths target in first Ratex paper was cob