Transcript Money wage

Slides for Part III-F
Outline
•The New Classical view of the business cycle
•The Phillips curve as solution to the mystery of the
missing equation
Friedman’s critique of the Phillips curve
•The accelerationist hypothesis
•Friedman’s demand for money function
•Policy implications of the New Classical economics
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
•Say’s Law
•The quantity theory of money
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 costof-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.
•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.
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
Real GDP
“Natural”
GDP
Actual
GDP
Time
First differences of Nominal GDP and M2
M2 is lagged one year
500
450
400
350
300
250
200
150
100
Nominal GDP
50
0
60
M2
65
70
75
80
Year
85
90
95
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 variable—that 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
The Phillips contribution1
Phillips empirical study
indicated an inverse
relationship between
unemployment and the rate
of increase of money wages
Data points for the
U.K. (annual)
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
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:
1
   
U
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.
Inflation-Unemployment Pairs for the U.S., 1955-69
7.0
www.bls.gov
69
6.0
5.0
68
4.0
66
67
3.0
56 57
65
2.0
58
59 63
60
62
64
1.0
61
55
0.0
3.0
3.5
4.0
4.5
5.0
5.5
Une mployment Rate
6.0
6.5
7.0
Inflation-Unemployment Pairs for the U.S., 1955-69
7.0
www.bls.gov
69
6.0
5.0
68
4.0
Phillips curve
66
67
3.0
56 57
65
2.0
58
59 63
60
62
64
1.0
61
55
0.0
3.0
3.5
4.0
4.5
5.0
5.5
Une mployment Rate
6.0
6.5
7.0
The (inverted J) shape of the Phillips curve
apparently gives
policy makers an exploitable trade-off
between inflation and unemployment.
Moreover, the champions of the Phillips curve
ostensibly believed that the policy trade-off
was “stable”—that is, the terms of the tradeoff would hold up over time
The (MIT) Keynesian view went like this:
Find the “politically acceptable” trade-off
and use “active” aggregate demand
management to achieve it.
Policy target
Phillips curve
0
Unemployment rate
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:
1. 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.
2. “There is no long run trade-off between inflation and
unemployment.” Suggests there may be a short-run tradeoff.
3. 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.
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.
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
Assumptions
1. Asymmetry of information--i.e., employers correctly forecast
price level movements and employees sometimes do not. Labor
is subject to “money illusion.”
2. “Adaptive” expectations on the part of labor.
With respect to (2) we have

E
t

A
t 1
Which is to say that labor adjusts to changes in the
price level with a one-period lag.
Money illusion is a failure
to perceive that the value
of money (and hence,
a given money wage)
has changed
Recall we said that NS=f(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.
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. WA=w/pA, where
pA is the actual price level.
Labor is subject to money illusion if:
WE  WA
12
11
10
When the price level
rises from 1.00 to
1.20, employers
adjust immediately
and increase their
NS (Pe = 1.2)
demand for labor.
NS (Pe =1.00) In the short-run, Y can
exceed its “natural”
level
ND (Pe = 1.00)
ND (Pe = 1.2)
0
NN N’
Employment
The long-run Phillips curve is vertical at the NAIRU
Inflation rate
LP E = A
0
E
<
E > A
A
UN
Unemployment rate
Short-run Phillips curves intersect the long-run Phillips
curve at the expected rate of inflation
LP E = A
Inflation rate
12
SP2 :E =12%
3
SP1: E = 3%
0
UN
Unemployment rate
LP E = A
SP3
SP4
Inflation rate
8.1
S
SP2
Monetary
deceleration
produces
stagflation
4.6
2.0
0
SP1
UT
UN
Unemployment rate
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.
Inflation-Unemployment pairs for the U.S., 1960-89
16
14
80
12
7479
81
10
75
1960-69
8
69
78
6
66
67
65
2
82
76
89
88 71
87
72
68
4
77
73
70
64
84
85
1980-83
83
86
6063
62
61
0
3
4
5
6
7
Unemployment Rate
8
9
10
Summary
•Money is non-neutral in the short-run—that 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.