EC301 Macroeconomic Policy
Dr. Derick Boyd
UNIVERSITY OF EAST LONDON
EAST LONDON BUSINESS SCHOOL - ECONOMICS
fn. 301 Milton Friedman and the monetarists - natural' unemployment and the limits
of government
ECO301 MACROECONOMIC POLICY
MILTON FRIEDMAN AND THE MONETARISTS: 'NATURAL'
UNEMPLOYMENT AND THE LIMITS OF GOVERNMENT
We began developing our understanding of the Classical economic model in the form
of Say’s Law and the Irving Fisher Quantity Theory of Money Equation and their
interaction. We saw that the tendency for the model to tend to equilibrium depended
on ‘automatic adjustments’ brought about through the perfectly flexible adjustment in
prices (notably real interest rate and real wages). Last week we examined the attack
on the Classical model led by Keynes and Kalecki.
We saw that the attack on the Classical model began from the late 18th century but the
successful development of a theoretical argument to counter the Classical notion that
the economy tended toward some form of optimal operating conditions – was not
until the 1936 publication of John Maynard Keynes’ General Theory of Employment,
Interest and Money. The automatic adjustment to equilibrium, a fundamental feature
of the Classical model, was criticised. Keynes argued that the price mechanism in the
Classical model would not always produce optimality conditions, that is:
(i)
real interest rates may not adjust to bring about full-employment
equilibrium; and,
(ii)
the real wage rate may not flexibly adjust to bring about fullemployment in the labour market.
We further saw that Keynes provided an alternative model and we examined in detail
the role of interest rates in the Keynesian model. We noted the extreme case of the
liquidity trap where investment could not be induced by further falls in interest rates
and noted Krugman's use of this in explaining Japan's prolonged economic crisis.
Keynes' objective was to build a model that would convince economists that
economies can operate at under full-employment equilibrium and would not
necessarily tend to full-employment equilibrium as the Classical model contends. If
Keynes was correct this could be seen as the basis for government intervention in the
economy, i.e. government policy to influence the working of the economy.
The Keynesian argument led in turn to the development of a defence of the Classical
approach, in particular, it led to the restatement of arguments that 'government
intervention' was unnecessary and perhaps downright harmful to the economy. We
shall consider an important part of this Classical defence in terms of Milton
Friedman's expectation augmented Philips Curve analysis - see Acocella, section
7.4.4, pp.143-162.
Friedman and the monetarists conceive the market economy as intrinsically stable,
unlike Keynes and the Keynesians. They do not deny that instability may exist in real
life situations but they attribute it to government interventions rather than to the
fundamental state of the market economies. In developing our understanding of
Friedman’s alternative analysis to Keynes, I want us to clearly understand two of
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Dr. Derick Boyd
Friedman’s theoretical constructs that are fundamental to what became the
monetarists’ approach:
(i)
Friedman’s restatement of Irving Fisher’s Quantity Theory of Money
that we examined in a previous essay;
(ii)
Friedman’s Expectation Augmented Phillips Curve.1
This theory postulates a causal, direct and proportional relationship between the
quantity of money and the price level, assuming a constant level of money velocity.
Friedman’s restatement starts with the Fisher equation rewritten as MV = PT, where
M is the quantity of money, V velocity, P the price level and T transactions. If we
exclude financial transactions from T and consider the structure of the real economy
as given, we can replace T with income Y , which we can see as aggregate market
output or equivalently the aggregate real income of the economy. Since T has been
replaced by Y then V is no longer the transactions velocity of money, but rather the
income velocity of money. So we can write MV = PY where PY would represent
nominal income and if M is the quantity of money then V is the income velocity of
money (the number of times the money circulates to accommodate the particular
nominal aggregate income). Furthermore, if we replace velocity with the fraction of
income individuals wish to hold as money balances, k (the inverse of velocity), we
can rewrite the Fisher equation as M=kPY - the form of the Friedman
restatement2. If k is constant as Friedman assumes, changes in M will be reflected
in nominal income, PY.
Friedman considers money as one of various forms of wealth. It is not, as it is for
Keynes, an alternative to fixed interest securities only – explained in the liquidity
preference theory of money we examined earlier. For Friedman, money belongs to
the entire spectrum of assets, both financial (of various maturities and forms) and real
(individual durable goods like land, houses, gold, firm’s assets...). Within this
framework, changes in the nominal quantity of money – at initially given prices – will
cause changes in the real quantity of money, changing spending on securities and real
goods. It is precisely the real balance effect that serves as the transmission
mechanism of monetary policy according to Friedman.
So, based on this restatement of the Fisher quantity equation, Friedman argues that
changes in the money supply are the principal systematic determinants of the growth
of nominal income. Friedman does not say that changes in money just all go into
inflation however. As Acocella (p.143) states, there is a “seemingly greater openness
of neo-quantity theorists to the possibility that money does not affect just prices but
also real income in a limited way”. There is a sting in the tail, however, for Friedman
goes on to show that changes in money can only affect real income in the short run
and will always be associated with increased inflation. So government intervention is
not benign as the Keynesian approach indicates – allowing coordination problems and
market failures to be corrected. For Friedman, even if income and employment can
be increased through government intervention, the cost of those increases is inflation
1
There are two aspects to this, the first is that you should be able to understand and explain this as a
technical device, and the second is that you should be able to place it in the context of the development
of the macroeconomic policy literature.
2
In order to really understand the meaning of k fill in some numbers in the equations LsV  pY and
convert it to the final form
Ls  kpY , it is really quite simple.
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Dr. Derick Boyd
and the increases will only last a short while. Friedman’s explanation of this resides in
the second technical construct that I wish us to examine in the Expectation Augmented
Phillips Curve.
Let us examine in detail the behaviour of the market unemployment rate using the
‘expectation augmented’ Phillips Curve. The original Phillips curve (which was
statistically observed in Phillips 1958, and is widely used by Keynesians) is the
inverse relationship between the rate of change in money wage rates, w , and the
unemployment rate, u , where the relationship is written as
w    u  , with    0 .
According to Friedman, this relation is unlikely to remain stable over time.
Figure 1
r/g wage inflation
Phillips
Curve
r/g unemployment
U*
The curve as developed by Professor A.W. Phillips and employed in Keynesian
analysis was regarded as showing a relationship between inflation an unemployment
that could be described as a trade-off relationship, see Fig 1. It was for a while
thought as showing that governments could trade off some unemployment for some
inflation - i.e., governments may choose to have low unemployment and higher
inflation or they may choose to have a lower rate of inflation and higher
unemployment. The Phillips curve may be seen, therefore, as underlying the notion
that there is a role for government intervention. This relationship occupied an
important place in macroeconomics until the 1970s when economies started to
experience both high unemployment and high inflation - so no trade-off seems to
exist. The persistence of stagflation indicated that this relationship, even if existed
before, obviously did not hold anymore.
The attack on this Keynesian notion and the development of a theory to explain
stagflation was established my Milton Friedman and Edmund Phelps in the form of
the expectation augmented Phillips curve analysis. This would again represent a
return to the more classical notion that the economy will tend to a 'natural full-
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Dr. Derick Boyd
employment output' level of operation - how this is defined we will learn in what
follows3.
Figure 2
r/g wage inflation
U*=NAIRU
r/g unemployment
PE2
U/
PE1
*
U
PE0
Friedman does not refer to 'voluntary' and 'involuntary' unemployment. 'Voluntary'
unemployment is replaced by 'the natural rate of unemployment'. This is now the level
of unemployment associated with market clearing. It allows for unemployment caused
by structural factors. The important point about the natural rate of unemployment,
however, is that it does not include unemployment caused by lack of aggregate
demand. Thus, the government cannot reduce the natural rate of unemployment by
increasing aggregate demand.
It is worth noting some things from Acocella's account. Firstly, the two crucial
assumptions of the Friedman/Phelps model are (p. 144):
(i) expectations are adaptive; (ii) firms are better informed than workers are about
price increases and that (iii) also implicit in the original Phillips curve is the
assumption that expected inflation is zero. That is, workers always assume that the
existing money wage equals the real wage.
Tutorial Questions
1(a) Explain Irving Fisher’s quantity theory of money and Friedman’s
restatement of the Fisher equation. What, if any, additional insight does
Friedman’s restatement provide?
(b) Acocella writes, "Friedman and the monetarists conceive that market
economy as inherently stable. Monetary policy is effective only in the short
run; in the long run there is no trade-off between inflation and
3
There are two aspects that we need to bear in mind, one is the internal consistency of the theoretical
device (the expectation augmented Phillips curve in this case), and the other is the context in which
theory developed and the role it plays in establishing a competitive macroeconomic paradigm.
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Dr. Derick Boyd
unemployment." Explain Friedman's and the monetarists' argument and its
relationship to the Keynesian proclivity to interventionist policies.
2.
For Friedman and many monetarists, government intervention is never
benign - even if income and employment can be increased through
government intervention, the cost of those increases is inflation and the
increases will only last a short while. Elucidate and explain.
*********
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