Slides for Part IIIF

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Slides for Part III-F
The New Classical Economics

• Outline
• The New Classical view of the business cycle
• The Phillips curve as solution to the mystery of
  the missing equation
• Friedmans critique of the Phillips curve
• The accelerationist hypothesis
• Friedmans demand for money function
• Policy implications of the New Classical economics

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The New Classical Economics, Part I

• The New Classical Economics part I (also know as
  monetarism or the New Quantity) is accurately
  portrayed as a refurbished edition of the
  Classical theory of employment and, as such, is
  built on the following theoretical components
• Classical labor market analysis
• Says Law
• The quantity theory of money

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Key points

• Real or supply-side factors (N, K, R T)
  interact to determine the capacity of the economy
  to grow over time with price stability.
• The natural rate of output is the flow of output
  per time period that would be realized if labor
  markets were in a state of continuous
  equilibrium. Thus, the natural rate of output can
  be conceptualized as the inflation threshold for
  the macroeconomy--i.e., if the actual rate of
  output per time period exceeds the hypothetical
  natural rate, the cost-of-living will tend to
  rise at an increasing rate.
• Corresponding to the natural rate of output is a
  natural rate of unemployment (or
  NAIRU--non-accelerating inflation rate of
  unemployment) which is consistent with continuous
  equilibrium in markets for labor services.
•  

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• The natural rate of output is subject to change
  over time due to population growth, capital
  accumulation, the discovery of hitherto unknown
  natural resources, and technical change. Hence,
  it may be possible for real output to expand over
  time without inflation.
• A business cycle may be viewed as an episode
  wherein the macroeconomy is thrown off its long
  run growth path by some exogenous shock.
•  

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New Classical concept of the business cycle
A business cycle is an event in which the economy
is bumped off its long-run (natural) growth path
by monetary shocks
Natural GDP
Real GDP
Actual GDP
Time
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Mystery of the missing equation

• A frequent knock on Keynesian business cycle
  theory was its (alleged) failure to incorporate
  the price level as an endogenous variablethat
  is, there is no equation that links price level
  movements to changes in real GDP, employment, the
  balance of trade, etcetera.
• A path-breaking article by New Zealander A.W.
  Phillips in 1958 presented a solution to the
  mystery

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Phillips empirical study indicated an inverse
relationship between unemployment and the rate of
increase of money wages
The Phillips contribution1
Data points for the U.K. (annual)
Rate of change of money wages
0
Unemployment rate
1A.W. Phillips. The Relation Between
Unemployment and the Rate of Change of Money
Wages in the U.K., 1861-1957, Economica, Nov.
1958
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The Samuelson-Solow Contribution1

• Samuelson and Solow carried the Phillips work a
  step further by suggesting an inverse
  relationship between inflation and unemployment.
  Specifically, they estimated the following
  specification using U.S. data

Where ? is the inflation rate and U is the
unemployment rate. Hence we have a function that
makes inflation a reciprocal function of the
unemployment rate.
1P. Samuelson and R. Solow. Analytical Aspects
of Anti-Inflation Policy, American Economic
Review, May 1960.
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www.bls.gov
11
www.bls.gov
Phillips curve
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The (inverted J) shape of the Phillips curve
apparently givespolicy makers an exploitable
trade-off between inflation and unemployment.
Moreover, the champions of the Phillips
curveostensibly believed that the policy
trade-off was stablethat is, the terms of the
trade-off would hold up over time
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The (MIT) Keynesian view went like this Find the
politically acceptable trade-offand use
active aggregate demand management to achieve
it.
Inflation rate
Policy target
Phillips curve
0
Unemployment rate
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Professor Friedman delivered a blistering attack
on the Phillips curve at the American Economic
Association meeting in 1967
The Friedman critique of the Phillips curve1

•  3 central points
• The Phillips curve harbors a fundamental defect,
  namely, that the supply of labor is a function of
  the nominal wage. This violates a basic axiom of
  microeconomic theory.
• There is no long run trade-off between inflation
  and unemployment. Suggests there may be a
  short-run trade-off.
• The long run Phillips curve is vertical at the
  NAIRU or natural rate of unemployment.
•  
•  

1Milton Friedman. The Role of Monetary
Policy,AER, 58(1), March 1968, 1-17. 
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What is the NAIRU?
??

• NAIRU is an acronym for the non-accelerating
  inflation rate of unemployment.
• The NAIRU, or alternatively, the natural rate
  of unemployment, is that level of unemployment
  corresponding to equilibrium in the Classical
  labor market.
• The NAIRU is also defined as the rate of
  unemployment consistent with an unchanging (but
  not necessarily zero) inflation rate.
• Corresponding to the natural rate of unemployment
  is the natural level of real GDP.

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The Accelerationist hypothesis
Definitions

• UA is the actual rate of unemployment
• UT is the target rate of unemployment
• UN is the NAIRU or natural rate of unemployment
• ?A is the actual rate of inflation
• ?E is the expected rate of inflation
• LP is the long run Phillips curve
• SP is the short-run Phillips curve

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Assumptions

• Asymmetry of information--i.e., employers
  correctly forecast price level movements and
  employees sometimes do not. Labor is subject to
  money illusion.
• Adaptive expectations on the part of labor.

With respect to (2) we have
Which is to say that labor adjusts to changes in
the price level with a one-period lag.
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Money illusion is a failure to perceive that the
value of money (and hence, a given money
wage) has changed
19
Recall we said that NSf(w/p)that is, labor
supply is a function of the real wage, not the
money wage. However, workers may not know what
the real wage is at the point in time they
contract for the sale of labor services. They do
know the money wage. So they form an expectation
of the real wage based on their estimate of the
price level.
20
The Classical theory was (implicitly) based on
the assumption that agents have perfect
foresight. Prof. Friedman relaxed this assumption

• Let WE denote the expected real wage. WE w/pE,
  where pE is the expected price level.
• Let WA denote the actual real wage. WAw/pA,
  where pA is the actual price level.

Labor is subject to money illusion if WE ? WA
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When the price level rises from 1.00 to 1.20,
employers adjust immediately and increase their
demand for labor. In the short-run, Y can exceed
its natural level

Money illusion
NS (Pe 1.2)
NS (Pe 1.00)
12
ND (Pe 1.00)
Money wage
11
10
ND (Pe 1.2)
0
Employment
NN
N
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The long-run Phillips curve is vertical at the
NAIRU
LP ?E ?A
Inflation rate
?E gt ?A
?E lt ?A
0
Unemployment rate
UN
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Short-run Phillips curves intersect the long-run
Phillips curve at the expected rate of inflation
LP ?E ?A
12
SP2 ?E 12
Inflation rate
3
SP1 ?E 3
0
Unemployment rate
UN
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Modeling stagflation
LP ?E ?A
SP3
SP4
Monetary deceleration produces stagflation
8.1
S
SP2
Inflation rate
4.6
SP1
2.0
0
Unemployment rate
UN
UT
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Monetarism took off in the 1970s

• The monetarists, led by Professor Milton
  Friedman, experienced rising influence as
  inflation became public enemy number 1 in the
  1970s.
• Economists such as Edmund Phelps, Robert Lucas,
  and Thomas Seargent, subsequently added important
  modifications to the monetarist theory.

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1960-69
1980-83
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Summary

• Money is non-neutral in the short-runthat is,
  unanticipated changes in the supply of money can
  affect output and employment, as well as prices,
  in the short run.
• In the long-run, money is neutral.
• Deviations of the economy from its natural
  growth path are explained mainly by erratic or
  unforeseen changes in the money supply of money.
• Monetarists favor policy rules.