This paper takes the form of a playful discussion between two Australian economic students: Bert and Ernie. Bert seems to be arguing for the rational expectations theory, a proposition that boils down to the belief that the average consumer/investor know a lot about future policy, and the effects of that future policy. According to much of Bert’s argumentation, the knowledge and rationality of the average investor will be such that all government policy will be useless. Ernie, however, spends most of his time asking questions and raising objections. Bert begins the article by demonstrating for us graphically the classical monetarist approach; a price and income graph with a vertical supply curve, such that any increase in aggregate demand will translate directly (or in the long run) to a 1:1 increase in the price level.

A note: does the supply curve really have to be vertical, or just extremely inelastic such that prices always increase more than real output, and rather than leaving equilibrium at the point where the supply curve is unit elastic, employers, and consumers would rather stay there. Does this make sense?

Bert contends that the long-run Phillips curve is vertical. That means there is a natural rate of unemployment around which our economy will grow. “Government policy can bring about a departure from that only in the short run and then only by fooling people. But you can’t fool all the people all the time, Therefore, systematic policy is ineffective.” Indeed, later Bert points out that the only way to have any impact on the real output of the economy is by “inducing private agents to have mistaken expectations.” And so in doing this the government can have an impact that supercedes the expectations of the rational agents, however, the impact is likely to be negative and destabilizing

When an employer is deciding whether or not to hire someone, and that person is fully rational and information-imbued, he will need to take into account the future price of labor as well. Therefore, the temporary increase in aggregate demand that our monetary policy has bestowed upon us will not impress our employer. Nor will it impress the laborer, who will also anticipate the increased price level, and hence the later real wage reduction. This argument culminates to its apex on page 300 (of the reader). Why not just use a policy rule? “Any government that relies upon a policy rule—one that has a fixed growth of the money supply—will never cause any deviation from the natural rate. A random policy will affect real output. But any policy rule that is systematically relate4d to economic conditions, for example one designed with stabilization in mind, will be perfectly anticipated, and therefore have no effect on output or employment…to have real effects [it] must be completely unpredictable.”

The significance of this is made clear by Friedman. After WWII, the Phillips curve was god; our government thought that it could systematically exploit the unemployment-inflation dichotomy using aggregate demand. However, rational expectations got in the way, and dissolved the Phillips curve. “If people have rational expectations they wont be fooled by systematic policy even in the short run so there is no scope for short run policy either. This explains why the Phillips curve became unstable the moment policy makers tried to exploit it.

Then Ernie retorts with an argument from the Keynesian model. Monetary expansion leads to an effect on the interest rates that shifts to economy to higher output level. Businesses will expect the increase in aggregate demand and start producing before the demand hits the economy. In this way, monetary policy is actually more effective because of expectations. However, for this to happen, policy makers must take into account the economic effect of the policy, and the expectations effect of the policy, such that their actions are well integrated into both.

Rodney Maddock and Michael Carter.  A Childs Guide to Rational Expectations.  Journal of Economic LIterature (1982) 20, March pp 39-51.

In the article “the Triumph of Monetarism,” the author Brad Long delineates the differences and similarities between monetarism and Keynesianism, arguing essentially that New Keynesianism is an implicit endorsement of monetarism because they both arise from the same foundations/assumptions.  We can understand New Keynesianism as asserting five major propositions.  1) Frictions within the pricing adjustment mechanisms cause business cycle fluctuations.  2) Monetary policy is generally better at stabilizing that is fiscal policy.  3) There is first a general long run trend, and business cycles are variations around that trend, rather than something completely different. 4) We should use policy rules, rather than being so idiosyncratic about decisions.  5) Stabilization policy will always be limited.  Monetarism, in its simplest form, says that the stock of money is most important determinant of interest rates and prices within the course of the business cycle.  However, the author spends the majority of this article explaining the variants of thought within the monetarist tradition, beginning with Irving Fisher. 

This is not simply Hume’s basic quantity of money theory, but rather the application of that basic model to function as a policy tool.  What was most significant about this “first monetarism” is not so much the theory itself, but rather the critiques and ideas that were born from the debate other “subspecies” monetarists like Keynes and Friedman.  In fact, monetarism of this sort was considered “useless” by Keynes, because it was only oriented to long run equilibrium, and “in the long we’re all dead.”

Chicago Monetarism was more sophisticated because it concentrated on the velocity money and the function of banks as multipliers of the money supply.  About the great depression, the Chicago school blamed the monetary and fiscal policies that “had “permitted banks to fail and the quantity of deposits to decline.”  Therefore, their policy prescription was to expand the money supply and run a big deficit.  There are a couple major cannons of Chicago Monetarism.  1) The velocity of money was not constant.  They believed this because inflation and deflation raised and lowered the demand for money (because the returns to investment go down and up).  During booms and busts people would spend or hoard respectively, causing a further variant on the velocity.  2) The control of the money supply was not straightforward or easy.  With a fractional reserve system and no deposit insurance, banks will be unsure about deposit demand and there will be huge swings in the deposit-currency ratio—these two things determine the money multiplier.  This means that aggregate indicators are important to old Chicago types.

Classical Monetarism is classical in the sense that we “classically” understand the world in terms of this school of thought.  Born from the Chicago tradition, this basically asserted that the government has some influence over spending and business cycle stabilization, as we see evidence for in the Volker Chairmanship during the 1970’s, when he ended inflation and facilitated growth using monetary policy (and some psychology).  The author also talks about “political monetarism,” but it’s boring and kind of silly, so I’ll end my post now. 

“The Triumph of Monetarism?” by J. Brad de Long, 1999 from Monetarism Webpage at http://cepa.newschool.edu/het/schools/monetar.htm

Phillips Curve

In this brief article entitled “Phillips curve,” (you can guess what the article is about), the author Michael Darby discusses the different approaches to explaining the negative non-linear relationship between unemployment and inflation. In the classical view, price and wage flexibility should maintain the economy at the full employment level. This view was synthesized with the keynsian explanation, in so far as the high unemployment of the 1930’s was attributed to sticky wages levels, not accounted for in the classical approach. This relationship was confirmed in 1958 by A. W Phillips, Irving Fisher in 1928, and Richard Lipsey in 1960; however for the most part, these economist recognized the tad off between price (rather than wage) inflation.

The Keynsian approach implicitly assumed that inflation could only happen when demand was in excess of full employment output. During the 50’s and 60’s however, inflation did not always coincide neatly with full employment; in part because of the immobilities of the labor market, where premature inflation would ensue long before the point of 0% unemployment. Another explanation looks to the behavior of unions and big business, which exert a stronger influence during times of increasing demand. And so there was a definite trade-off posed between full employment (at 4 percent unemployed) and higher inflation (thought to naturally rest at 3.5%). The expectations augment Phillips curve came about as a result of the stagflation during the 1970’s—where the US experienced rising inflation and unemployment at the same time. The Phillips curve adherents thought that this was simply a rightward shift in the Phillips curve; a movement that reflected the greater representation of women and teenagers, and energy costs, such that any given rate of inflation now corresponded with a higher level of unemployment.

The role of expectations became relevant to the Phillips curve, when Edmund Phelps and Milton Friedman in the 1960’s proposed that “the natural rate of unemployment in a state of equilibrium emerges whenever inflation is completely anticipated.” When there is no supply pull or cost push inflation, the rate of inflation corresponds exactly with the expected rate of inflation, and unemployment is stable at the “natural rate of unemployment.” With an expansionary monetary or fiscal policy, employers will see the increase in prices before their workers will, thus workers are now relatively cheaper, hence encouraging the employer to hire more workers—thus employment increases, but only until the workers realize that their wages have actually decreased. Employment will then resettle at the natural rate of unemployment. Therefore, in the long run we see that the Phillips curve is perfectly vertical, only through bouts of inflation can we elevate the employment rate above the natural rate.

The new classical perspective is, as we might expect, more critical of government involvement. Because of the increasing prevalence of information, the decision making ability of rational agents is now considerably more accurate, such that there is no longer any difference between actual and expected inflation. Any of the unexpected variance in GNP can arise from a number of sources including unexpected fiscal and monetary policy changes (also including warfare and energy shortages). When there is an unexpected increase in the price level, a business could mistakenly interpret the inflation as an increase in demand, thus encouraging the firm to produce more and raise GNP above potential. Then the business is disappointed when demand does not come through, and they cut production and lower prices. In this view, government intervention only contributes to instability because it disrupts the rational behavior of market agents.

Darby, R. Michael. Phillips Curve. In Greenwald, Encyclopedia of Economics, pp. 778-782 (in the Reference Room, call number HB 61 E55 1994)

In contrast to the classicals, Keynes was of the opinion that some government intervention was necessary or at least helpful in facilitating the smooth functioning of the “invisible hand.” In this article, “Keyesian economics: First Principles,” the author characterizes the Classical economimics approach as “reductionists,” or essentially linked and represented by an analysis of individual choices. In this way the classical economics missed the boat on macroeconomics. The author points out that market equilibrium and choice logic is not always consistent—however market equilibrium is not necessarily part of the reductionist approach, but rather motivated by the desire to simplify things.The author then differentiates between different modes of Kynesian economics, the first interpretation being “fundamentalist”. Those who see keynes as a complete disavowal and affront to classical economics, are referred to as fundamentalist; the rationale behind this lies in the Keynesian liquidity preference theory, by which all prices are now money prices and hence subject to “expectational and conventional elements that characterized Keynes’s theory of the rate of interest.” Coddington illuminates another criticism of reductionist theories. For example, moods and emotions are widely shared during a riot, only to revert back to normal after the people have dispersed. Choice theory in the reductionist model fails to capture this interdependence of expectations and action; elements of human behavior that have a significant impact on the market.

In the book Macroeconomic Theory by Gardner Ackley, there is a section exclusively reserved for “classical macroeconomics.” It is a long section, so I ready only the first half; a beautiful account of Say’s law and the quantity theory of money as it applies to wages, production and prices.

Ackley began his section with a discussion of supply and demand. But rather than a simple explanation, the author tried to draw out a distinction. To say that Supply = Demand, is make a statement of identity: whatever is sold, must also be bought. However, to posit a chain of causation between them, is to argue and economic theory. This is in reference to Say’s law, a theory that states simply: supply determines spending. A mans production will determine the amount of commodities that he has to trade with others. Each man’s production (supply) constitutes his demand for other goods, and hence the aggregate demand must in some sense equal the aggregate supply. This is founded upon the assumptions that “people do not want money for its own sake,” and hence “the world must work at full employment.” As Ackley points out, Say’s law is not the income-expenditure identity because this version of the model assumes full-employment. Any increase in production (supply) will also increase income and spending.

The quantity theory of money is another example of classical reasoning, although it is significantly different from say’s law (a theory that was originally intended to describe the economics of barter).

MV = PT M = supply of money

V = velocity of money

P = average price level

T = the quantity of or physical volume of transactions.

Given that the transactions velocity of money is a constant (because non-active money is always zero), and T is always at its maximum value given the full employment condition, then prices are contingent upon changes in the money supply.

In Chapter VI, Ackley’s then discusses more in-depth the classical model of wages, prices and full employment. He re-demonstrates much of what we already have learned in our intermediate Micro class. Namely:

M / P = W

P x MPL = VMPL and W

MC = W / MPL

These equations belong to the classical approach because they assume full employment. These equations are relevant to the classical macro approach when we further assume that absence of idle balances (all money is being used in the economy). The major contribution of Ackley’s discussion, is simply that the aggregate level of output in the economy does not depend on the level of prices, but rather the structure of prices — the interaction of wages and prices as they determine the real wage rate and aggregate demand.

 Ackley, Gardner.  Macroeconomic Theory.  The Macmillan Company, New York: 1961.

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