Transcript lecture 5. inflation

History of Modern Macroeconomics
Lecture 3.5. The Problem of Inflation (1950-1970)
Kevin D. Hoover
Department of Economics
Department of Philosophy
Center for the History of Political Economy
Duke University
Center for the History of Political Economy Summer School
June 2014
1
Consumer Prices in the United States, 1774-2003
Log Scale
1000
Beginning of
Bretton Woods
100
Revolutionary
War
Civil War
Great
Depression
World War II
10
World War I
War of 1812
End of the Gold
Standard
Source: Historical Statistics of the United States
1
17
70
17
80
17
90
18
00
18
10
18
20
18
30
18
40
18
50
18
60
18
70
18
80
18
90
19
00
19
10
19
20
19
30
19
40
19
50
19
60
19
70
19
80
19
90
20
00
Index (1982-84=100)
End of Bretton
Woods
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Retail Prices in the United Kingdom 1770-2009
1000
Index 1987=100
100
End World War II; being
Bretton Woods
Napoleonic Wars;
suspension of gold
convertibility
Resumption of gold
convertibility
World War I; suspension
of gold standard
Reinstatement of gold
standard
End Bretton Woods
10
World War II
End of gold standard
17
70
17
80
17
90
18
00
18
10
18
20
18
30
18
40
18
50
18
60
18
70
18
80
18
90
19
00
19
10
19
20
19
30
19
40
19
50
19
60
19
70
19
80
19
90
20
00
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The Postwar International Monetary
Order
Bretton Woods Conference 1944
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The Wartime Controlled Economy
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Two Types of Inflation
Demand-Pull
↑AD  ↑expenditure > AS  ↑p

Cost-Push
↑ factor price (materials or w)  ↑ p [markup
relation]  further ↑ w [wage-price spiral]

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Cost-Push Inflation vs. the Quantity
Theory

Quantity Theory of Money Slogans:



“Too much money chasing too few goods”
“Inflation is always and everywhere a monetary
phenomenon” – Milton Friedman
Misses Historical Issue



no one deny’s continuous inflation requires rising AD
but V flexible enough in immediate to intermediate run 
↑p independent of M
interaction of cost structure and AD  small ↓AD  large
↑U [an imperfectionist view]
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Problem of Modeling Inflation


IS-LM and econometric descendants designed to
model level not inflation of prices
No good account of price setting:

Who sets prices?



Kenneth Arrow, "Toward a Theory of Price Adjustment",
1959.
Absence of the Walrasian auctioneer
socialist calculation debate (1930s/1940s)



Oscar Lange On the Economic Theory of Socialism, 1938; Price
Flexibility and Employment 1944
Abba Lerner The Economics of Control, 1944.
Friedrich von Hayek “The Uses of Knowledge in Society”
(AER 1945)
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A.W.H. Phillips (1914-1975)




Electrial Engineer
Prisoner of War
L.S.E. Ph.D (dissertation on the building and
operation of the Moniac [a.k.a. the Phillips
Machine])
Econometrician with interest in dynamics:




"Some Notes on the Estimation of Time-forms
of Reactions in Interdependent Dynamic
Systems", 1956, Economica
"Stabilisation Policy and the Time Form of
Lagged Response“ (EJ 1957)
"The Estimation of Parameters in Systems of
Stochastic Differential Equations“ (Biometrika
1959)
"Estimation of Systems of Difference
Equations with Moving Average
Disturbances” (Econometrica, 1966)
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Phillips Implicit Dynamic Model

w = w-1 + U-1 –[w – f(U)]-1 + 




w = log(wage rate)
w = rate of wage inflation
U = unemployment rate
 = error term
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The Original Phillips Curve
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Estimation of the Phillips Curve
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Stability of the Phillips Curve
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Dynamics of the Phillips Curve - 1
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Dynamics of the Phillips Curve - 2
w = –0.9w-1 – 0.3 U-1 – 0.1[w + (–0.9 – 9.638U-1.394)]-1 + 
Rate of Wage Inflation
3
2
1
0
2
2.2
2.4
2.6
2.8
3
3.2
3.4
3.6
3.8
4
Unemployment Rate
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Phillips on Cost-Push

Cost-push elements:




Import prices
Agricultural prices
Wages through cost-of-living adjustments and
contracts
COLAs only if real wages (w/p) actually fall; only
if p rise exceeds productivity growth (typically
from non-demand source)
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Relationship of Prices to Productivity


Perfect competition: w/p = mpL = Y/L =  for
Cobb-Douglas production function (  labor
productivity;   labor’s share in national income)
w – p =  or p = w – 


Note:  = log difference, so x = logx – logx-1
Similar results for non-Cobb-Douglas and for
markup equations
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The Phillips Curve Comes to America
Paul Samuelson (1915-2009)
Robert Solow (1926- )
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The U.S. Phillips Curve
Wage Inflation/Unemployment
Scatter
Price Inflation Phillips Curve
Samuelson and Solow, “Analytical Aspects of Anti-Inflation Policy,” AER Papers and Proceedings 1960
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U.S. Phillips Curve Not Stable in Long
Run

Wage inflation scatter does not lie on a simple curve

Phillips curve may shift because of policy:

Possibilities for a “low pressure economy”:



Virtuous outcome: improved expectations  lower U
compatible with constant price inflation (cf. post-Volcker
1980s)
Vicious outcome: constant price inflation requires high U 
↑structural U (cf. hysteresis Europe 1990s; current arguments
about deskilling)
Reversible (useful for macro policy) only in short run
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Reception of the Phillips Curve
Articles in JSTOR
Using “Phillips Curve”
Year
Number
1959
1
1961
4
1962
0
1963
6
1964
8
1965
15
1966
13
1967
40
1968
78
1969
71
1970
77
Post-1970
4,420

Economics citations in
JSTOR:


Oldest (1959) in comment
on original Phillips paper
Non-economics
citations:


Total 912
Earliest 1971 in Political
Science journal
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Friedman’s Presidential Address



“The Role of Monetary Policy,”
AER Papers and Proceedings, 1968
Negative thesis: Phillips & Co.
wrong, perhaps incompetent
Positive thesis: market-clearing
microeconomics adequately
accounts for the relationships of
wage (and price) inflation and
unemployment
Milton Friedman (1912-2006),
Nobel Laureate 1976
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Friedman’s Presidential Address:
Negative Thesis

Attack on Phillips and Phillips Curve:


Mistakes nominal and real quantities – false
Assumes curve stable



false in short run – notes shift in dynamic processes
true for Phillips in long run – but an empirical discovery,
not a point of principle; false for Samuelson & Solow.
Specified for an environment with zero long-run
inflation


true for Phillips (but again contingent)
false for Samuelson and Solow
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Friedman’s Presidential Address:
Positive Thesis


Real and nominal independence in the long run
Unique equilibrium in the labor market  natural rate of
unemployment:
“. . . the level that would be ground out by the Walrasian system of
general equilibrium equations, provided there is imbedded in them the
actual structural characteristics of the labor and commodity markets,
including market imperfections, stochastic variability in demands and
supplies, the cost of gathering information about job vacancies and
labor availabilities, the costs of mobility, and so on.”
Milton Friedman, “The Role of Monetary Policy”

Concedes existence of short-run Phillips curve
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Edmund Phelps as Co-discoverer of the
Natural Rate Hypothesis


"Phillips curves,
Expectations of Inflation
and Optimal
Unemployment Over
Time.” Economica, 1967
Admired, but less
influential than Friedman:

less accessible



Edmund Phelps (1933- ),
Nobel Laureate 2006
theoretical paper vs.
conversational, popular
format
less visible journal
not committed to free
market/monetarist
program
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Challenge of Explaining the Short-run
Phillips Curve – 1
Expansionary monetary
policy raises the inflation
rate 
Movement along original
Phillips curve and ↓U
1.
p
2.

Phillips Curve
(1)

(2)
(2)
(3)
NRU

(3)
U
3.
firms see ↓ w/p as w
unchanged, so ↑LD
workers see ↑w/p rise when
firms begin to compete for
labor, so ↑LS
net ↑L rises; ↓U
Phillips curve shifts over
time as workers adjust
expectations to higher rate
of inflation and ↑U to NRU
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Challenge of Explaining the Short-run
Phillips Curve – 2

Asymmetry of information:



Difference between long and short run:




Firms form correct expectations of inflation
Workers form correct expectations only with a lag
Phillips curve exists in the short run
Long-run Phillips curve vertical at the natural rate
Long-run for Friedman: “ . . . something like two to five
years . . . [with] full adjustment [in] . . . say, a couple of decades.”
Causal direction


Phillips and Samuelson & Solow: U (measure of AD)
causes p
Friedman: p causes U (measure of AS)
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Reception of the Natural Rate Hypothesis

Friedman as prophet:


widely credit with foreseeing high inflation of 1970s
expectations-augmented Phillips curve compatible with
natural rate hypothesis widely adopted:


p = pe + f(U) + 
accelerationist version: p = p-1 + f(U) +  or
p = f(U) + 


rapidly became standard in textbooks
Citations in JSTOR to Phillips Curve after 1968 = 96
percent of total citations
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NAIRU and Keynesian Pushback





Keynesians adopted expectations-augmented
Phillips curve
Alternative interpretation:
Retained Phillip’s causal direction: U (measure of
AD) causes p
Objected to persuasive terminology of natural
Alternative NAIRU:


non-accelerating inflation rate of unemployment
terminology seems to have arisen in Brookings Institution
c. 1976
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Friedman: Maker of the Phillips Curve,
Seed of a Mythology

Myths fostered by Friedman:





Phillip’s curve rested on real/nominal confusion
users believed it to be stable over time
users believed it provided enduring policy
tradeoff between inflation and unemployment
influential in 1960s macroeconomic policy
Myths about Friedman:

Friedman anticipated stagflation
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Thanks

The End
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