CHAPTERS IN ECONOMIC POLICY
Part. I
Unit 4
From the Monetarism to the “New Keynesian
Economics”
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 maximizing 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 moral hazard 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