Lecture Seven

1
Lecture Seven

• The Breakdown of Keynesianism
• The Rise and Fall of the Phillips Curve
• The Neoclassical Revival
• The Keynesian Counter-attack logical flaws in
  Neoclassicism

2
Recap

• IS-LM dominates interpretation of Keynes
• Keynes a marginalist liquidity preference as
  marginal cost of interest foregone in holding
  money
• Role of expectations under true uncertainty
  ignored
• Neoclassical synthesis combination of IS-LM
  macro with Walrasian micro

3
Breakdown of Keynesianism Philips Curve

• 1958 study identifies relationship between
  unemployment rate of change of money wages
• Consonant with Keynes on real wages and
  employment
• Inc. output --gt decrease real wages --gt prices
  must rise
• Inflation-unemployment trade-off perceived as
  core of Keynesian policy
• 1960s--accelerating inflation. Breakdown of
  Philips Curve opens door to Friedmans monetarism

4
The Phillips Curve

• 3 factors which might influence rate of change of
  money wages
• Level of unemployment (highly nonlinear
  relationship)
• Rate of change of unemployment
• 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
• Cost-based perspective on prices
• Developed curve from UK wage change/unemployment
  statistics from 1861-1913
• Only 1st of 3 causal factors shown in curve

5
The Phillips Curve

• 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 exponential curve to data

6
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
7
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
8
The Phillips Curve 49-57 data with time lag
Close fit of 50s UK data to curve
Import price rise
9
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.
• Nonetheless, trade-off interpretation becomes
  part of orthodox Keynesianism

10
The Phillips Curve Breakdown?
OPEC I
Vietnamwar
OPEC II
11
The rise of monetarism

• Friedmans explanation adaptive expectations,
  the short run trade-off but long run vertical
  Phillips curve
• Basic model
• Exogenously given money-supply (helicopters)
• Walrasian economy in long-run equilibrium all
  prices currently market-clearing
• No sale of capital assets possible
• Static-stochastic economy no growth, aggregates
  constant, but random disturbances to individuals
• 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. OREF II 119

12
Monetarism

• Basic model (cont.)
• Motives for holding money
• Transactions (barter motive)
• uncertainty says Milton, but means of
  aggregates constant, stochastic variation only?
  Risk, not uncertainty.
• No variation in parameters of risk considered
• Holdings of money related to level of
  transactions
• Md k.I
• Exogenous increase in Ms--gt
• initial increase in output but constrained by
  already fully-employed economy
• price level bid up till real value of money
  holdings restored

Back to Hickss pre-Keynesiantypical classical
theory
13
Monetarism

• Continuous growth in Ms?
• (corresponds to policy for lower U under Phillips
  curve inflation/U tradeoff)
• which, perhaps after a lag, becomes fully
  anticipated by everyone adaptive expectations
  OREF II
• results in
• Adaptive Expectations (with certainty)
• what raises the price level, if at all points
  markets are cleared and real magnitudes are
  stable? ... Because everyone confidently
  anticipates that prices will rise OREF II
• Increasing Ms raises prices, no impact on output
  in long run (short run impact until expectations
  adapt)

14
Adaptive Expectations and the Phillips Curve
Long run Phillips Curve
Target Rate
Accelerating inflation needed to sustain target
Short run gain with long run pain...
Inflation
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
15
From Monetarism to Rational Expectations

• Friedman adaptive expectations
• expectations adapt to change after experience of
  inflation caused by increased money supply
• short-term impact of policy neutralised in long
  term
• Rational Expectations (Muth/Sargent)
  expectations predict consequence of change based
  on rational model of reality
• expectations are essentially the same as the
  predictions of the relevant economic theory.
  OREF III
• Combined with lag formulae as explanation for
  cycles

16
Rational Expectations Macro

• the public knows the monetary authoritys
  feedback rule and takes this into account in
  forming its expectations unanticipated movements
  in the money supply cause movements in y
  output, but anticipated movements do not.
  OREF III
• Predictions of relevant theory are increased
  Ms will increase price level --gt instant
  adjustment of prices to government Ms policy --gt
  no impact on output
• Natural rate of unemployment rational
  expectations policy ineffectiveness hypothesis

17
Rational Expectations Macro

• by virtue of the assumption that expectations
  are rational, there is no feedback rule that the
  authority can employ and expect to be able
  systematically to fool the public. This means
  that the authority cannot expect to exploit the
  Phillips curve even for one period. OREF
• A vertical Phillips curve in short run
• Prediction that policy could never have been
  effective
• Short-run movements in unemployment due to
  unanticipated shocks

18
Problems for Rational Expectations

• (1) Was Keynesian policy ineffective? (see next
  table)
• By RE, differences between Keynesian
  Neoclassical policy periods should be
• Higher M growth, Inflation
• No difference in unemployment
• (2) Why the Great Depression?
• Natural rate moves by 30???
• (3) Movement of natural rate (hysteresis?)
• (4) Nature of expectations
• Keynes behaviour under fundamental uncertainty
• RE behaviour under certainty, using economic
  theory to predict

19
The Keynesian/Neoclassical Scorecard
Outcomes contradict RE Hypothesis Keynesian
period has Lower Money Growth, Inflation,
Interest Rates, Unemployment Higher Growth
How could this be if policy was
ineffective?Did the economy suddenly
deteriorate? (possibly true)
20
Theoretical Developments

• Behind policy fight, theoretical battles
• Perfection of Walrasian GE model (Arrow-Debreu)
• Classically-inspired critique of neoclassicism
  (Sraffa)
• Arrow-Debreu General Equilibrium
• proof of existence/uniqueness/stability/optimality
  of equilibrium (completing Walras work), but
• under assumptions of given resources, given
  tastes, given possible future states of world,
  contingent contracts, and no uncertainty, and
  peculiar definition of commodities
• The Keynesian Critique reality that factors of
  production are commodities, labour, land applied
  to show that neoclassical theory is internally
  inconsistent

21
The Cambridge Controversies

• Critique of neoclassical economics initiated by
  Joan Robinson, Piero Sraffa (Cambridge UK) over
  nature of capital vis a vis land, labour
• Theory defended by Paul Samuelson, Robert Solow
  (Cambridge USA)
• Focus of attack validity of neoclassical theory
  of distribution based on supply and demand

22
The Cambridge Controversies

• Neoclassical theory argues that
• increasing supply of factor of production will
  reduce its price
• reducing its price will increase its use in
  production
• Factors price equals its marginal product
• Direct relationship between supply of factor and
  its price
• Models production as
• involving factors of production (Land, Labour,
  Capital) as inputs and goods as outputs
• versus classical position goods produced using
  goods and labour as inputs
• The neoclassical position of profit and capital
  is

23
The Cambridge Controversies
Increasing supply Decreasing price...
Diminishing marginal product
Increasing use of factor relative to others...
Marginal Product
Rate of profit is the marginal product of capital
Capital
24
The Cambridge Controversies

• Sraffa, 1960
• Take economy in full general equilibrium
• All marginal changes complete
• What determines prices in full equilibrium if all
  marginal changes are over?
• Self-reproducing system of commodity production
• inputs commodities labour
• output commodities
• equilibrium prices of outputs must enable their
  purchase as inputs in next period
• System (1) Simple reproduction, commodity inputs
  only

25
The Cambridge Controversies

• 240 qr wheat 12 t iron 18 pigs --gt 450 qr
  wheat
• 90 qr wheat 6 t iron 12 pigs --gt 21 t
  iron
• 120 qr wheat 3 t iron 30 pigs --gt 60 pigs
• 450 qr wheat 21 t iron 60 pigs (sum of
  inputssum of outputs)
• Regardless of demand, prices must allow system to
  reproduce itself
• 450 qr wheat must buy 240 qr wheat, 12 t iron, 18
  pigs
• 21 t iron must buy 90 qr wheat, 6 t iron, 12 pigs
• 60 pigs must buy 120 qr wheat, 3 t iron, 30 pigs

26
The Cambridge Controversies
System of production
As a matrix equation
Has the solution
i.e., price system for simple reproduction
independent of demand, marginal utility, etc.
depends instead on system of production
27
The Cambridge Controversies

• System (2) Expanded reproduction
• surplus produced, must be split between
  capitalists and workers
• in equilibrium, a uniform rate of profit r,
  uniform wage w

28
The Cambridge Controversies

• r w values determine split of surplus between
  capitalists, workers. To determine prices, must
  therefore know either r or w beforehand
• Distribution therefore not determined by market
• Instead, different pattern of prices for every
  pattern of distribution marginal productivity
  theory of income distribution incorrect in
  general equilibrium
• But what about validity of production function,
  isoquants, when marginal changes still relevant?

29
The Cambridge Controversies

• Neoclassical position (by Samuelson)
• Concedes Classical position more factual
• output produced by heterogeneous commodities and
  labour, aggregate capital an abstraction
• But neoclassical position still defensible as an
  abstraction
• Samuelson (for neoclassicals) argues
• isoquants just a parable we use to teach students
• reality is different technologies, each with
  fixed ratio of capital to labour
• increase in price of capital will lead to less
  capital intensive technology being chosen

30
The Cambridge Controversies
Technology 1 low K/L ratio, used when K expensive
Envelope is isoquant
Technology 5 high K/L ratio, used when K cheap
Decreasing price of capital means more capital
intensive methods used, akin to simple parable
that decreased price means more capital used
31
The Cambridge Controversies

• As an aside, Samuelson ridicules classical
  theorys problems with labour theory of value,
  that capital-labour ratios must be the same in
  all industries.
• Problem Samuelson assumes each technology can be
  represented by a straight line relationship
  between capital and labour
• Garegnani shows that straight line relationship
  only applies if capital to labour ratio is the
  same in all industries
• If K/L ratios differ, each technology will be
  represented by a curve, not a straight line
• Curves can cut each other in more than one place

32
The Cambridge Controversies
Technology 1 low K/L ratio, used when K expensive
Envelope is isoquant
Technology 2 only used in intermediate K/L price
range
Technology 1 could also be used when K cheap
Problem known as reswitching simple
neoclassical parabledoes not work when multiple
industries considered.
33
The Cambridge Controversies

• Why a curved relationship?
• The definition of capital
• What is capital?
• Money?
• Machine?
• Both, obviously but how to add machines
  together?
• Money value only common feature
• but money value reflects expected profit
• rate of return and value of capital thus
  linked
• Sraffas solution reduce all machines to dated
  labour
• Machine today produced with
• labour last year, plus
• machinery inputs last year

34
The Cambridge Controversies

• If economy has been in long run equilibrium for
  indefinite past
• then all goods produced earned normal rate of
  profit r
• therefore value of machine now equals
• value of previous years inputs (labour and
  capital)
• multiplied by 1r
• Do it again replace last years machine inputs
  with
• labour and capital used to produce those machines
• multiplied by 1r
• Get a whole series of terms for the labor input
  each year multiplied by 1r, (1r)2, (1r)3
• Machine/commodity component reducible to almost
  (but not quite) zero.

35
The Cambridge Controversies

• Next the standard commodity
• Earlier, Sraffa shows how to devise a measure of
  value unaffected by the distribution of income
  the standard commodity
• When measured using this, there is a simple
  linear relationship between the real wage w, the
  rate of profit r, and the maximum possible rate
  of profit R

This can be reworked to give an expression for
the wage in terms of the rate of profit
36
The Cambridge Controversies

• Each years labor input to producing a machine
  today is thus broken down into
• the number of units of labor performed (say 1
  unit)
• times the wage rate w (now expressed in terms of
  r R)
• times 1r raised to the power of n, for how many
  years ago the labor was applied

Number of years ago that machine was made
Wage in terms of rate of profit
Rate of profit
Expression gives an unambiguous value for todays
capital input in terms of dated labor, but the
measured value of capital depends on the rate of
profit
37
The Cambridge Controversies

• So rather than the rate of profit depending on
  the amount of capital (marginal product theory of
  income distribution), the amount of capital
  depends on the rate of profit
• Second problem this relationship is very
  nonlinear
• First part falls uniformly as rate of profit
  rises
• Second part
• rises slowly as r rises
• rises rapidly as n (number of years ago rises)
• Two parts interact very unevenly
• For small change in r, second effect outweighs
  first as n rises
• For large change in r, first effect outweighs
  second for small n
• In between, cant pick whether increasing r will
  increase or decrease measured amount of capital

38
The Cambridge Controversies
Value of machine produced with one unit of labor
applied n years ago at a rate of profit r between
zero and 25 when R25
Made this year (n0)
Made 5 years ago (n5)
r0
r25
Measured value rises then falls as rate of
profit rises
Made 25 years ago (n25)
Made 10 years ago (n10)
39
The Cambridge Controversies

• Cant apply marginal productivity theory to
  capital
• return to capital cant reflect marginal product
  of capital
• measured amount of capital depends on rate of
  profit
• numerator/y-axis (r) and denominator/x-axis
  (amount of capital) are interdependent
• relationship is messy
• rises as r rises for a while
• then falls as r rises
• Rate of profit therefore cant be marginal
  productivity of capital

40
The Cambridge Controversies

• Numerous other facets to Cambridge Controversies
• Minority of neoclassicals who got involved in
  debate (Samuelson, Solow, Hahn, etc.) had 2
  eventual responses
• Grudgingly conceded critique had validity and
  started to develop alternative approaches to
  neoclassicism themselves (Samuelson, Solow)
• Abandoned attempt to make neoclassical economics
  relevant to real world and developed general
  equilibrium models as abstract thought
  experiments only (Hahn, etc.)
• Majority of neoclassicals assumed (wrongly) that
  debate won by neoclassicals and continued on as
  always.
• Raises issues of methodology (is economics a
  science?) discussed in 2 weeks. Next week,
  finance...