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CHAPTERS IN ECONOMIC POLICY Part. I Unit 4 From the Monetarism to the


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Title: CHAPTERS IN ECONOMIC POLICY Part. I Unit 4 From the Monetarism to the

From the Monetarism to the New Keynesian
  • Milton Friedman (1912?2006) was one of the most
    influential economists and political commentators
    of the XX century. In the 1960s and early 1970s
    he led the monetarist criticism against the
    Keynesian orthodoxy
  • Friedmans early contributions
  • Essays in Positive Economics, 1953 (a plea for a
    positivist approach in economics)
  • A Theory of the Consumption Function, 1957 (on
    the Permanent Income Hypothesis of consumption)

  • Friedman's criticisms of Keynesian theory began
    in 1956 with his restatement of the quantity
    theory of money (M. Friedman (1956), The
    Quantity Theory of Money A Restatement in
    Studies in the Quantity Theory of Money ed. by M.
  • In this work Friedman maintained that he demand
    for money
  • i) was highly stable
  • ii) it could not be regarded as infinitely
    elastic at some low interest rate (F. denies the
    liquidity trap)

  • More generally, Friedman and the monetarists
    maintained, contrary to Keynes, that in the
    medium-long run the economic systems tend to
    reach full employment equilibrium (Yn) ? provided
    that governments do not try to interfere
  • According to the monetarists, full employment
    does not mean that in equilibrium u0
  • In Friedmans view, the unemployment rate could
    not be sustained below a certain level, a level
    that he called the natural rate of unemployment

  • Furthermore, in his analysis of inflation and of
    the effects of monetary and fiscal policies,
    Friedman maintained that a key role was played by
  • Adaptive Expectation Hypothesis (AEH) (Friedman)
    for any given period, peoples expectations are
    modified by an amount which is proportional to
    the past errors
  • Pet Pet-1 ? (Pt-1 ? Pet-1)
  • Limits of this hypothesis It ignores the fact
    that economic agents take into account more
    information than simply the past behaviour of the

  • During the 1960s the debates between the
    keynesians and the monetarists centered around
    three main issues
  • 1) the Phillips curve
  • 2) the effectiveness of monetary policy versus
    fiscal policy
  • 3) the role of economic policy in the short run

  • 1) the Phillips curve
  • According to Friedman, the original Phillips
    curve did not take into account the fact that
    peoples expectations on future inflation play a
    key role in the wage determination process
  • By including expectations the Phillips curve
    equation becomes
  • pt pet ? a ut

  • Friedman denied therefore any stable trade-off
    between the rate of unemployment and the rate of
  • In any case, the unemployment rate could not be
    sustained below the natural rate of unemployment

  • During the 70s, contrary to the predictions of
    the original Phillips curve, the U.S. and the
    OECD countries were affected by both high
    inflation and high unemployment (stagflation).
    This was perceived as a major setback to the
    Keynesian model
  • The Phillips curve equation becomes
  • pt pet (? z) ? a ut

  • 2) the effectiveness of monetary policy versus
    fiscal policy
  • Friedman challenged the view that fiscal policy
    could affect output faster and more reliably than
    monetary policy
  • In A Monetary History of the United States,
    1867-1960, published in 1963, Friedman and Anna
    Schwartz reviewed the history of US monetary
    policy and came to the conclusion that monetary
    policy was not only very powerful but that
    changes in the money stock also explained most of
    the fluctuations in output
  • They interpreted the Great Depression as the
    result of major mistake in monetary policy.

  • 3) the role of economic policy in the short run
  • Friedman was skeptical that economists knew
    enough to stabilize output, and that policy
    makers could be trusted to do the right thing
  • He therefore argued for the use of simple rules,
    such as steady money growth. In his view,
    political pressures to do something in the face
    of relatively mild problems did more harm than

  • The New Classical Economics and the Rational
    Expectations Critique
  • In the early 1970s, Robert Lucas, Thomas Sargent,
    and Robert Barro (the intellectual leaders of the
    so called New Classical Economics) led a strong
    attack against the mainstream Keynesian
  • They argued that the predictions of Keynesian
    macroeconomics were incorrect, and based on a
    doctrine that was fundamentally flawed

  • The New Classicals
  • i) aimed to derive the aggregative behaviour of
    the economy from the basic principles of rational
    maxi- mizing firms and individuals
    (microfoundations of macroeconomics)
  • ii) maintained that rational expectations
    played a central role in explaining the dynamics
    of the economic systems
  • According to Lucas and Sargent, Keynesian
    economics had ignored, in assessing the
    effectiveness of monetary and fiscal policies,
    the full implications of agents expectations

  • However, the NCE also criticized Friedmans
    adaptive expectations hypothesis because this
    implied a backward looking behaviour by the
  • In Lucas and Sargents view, on the contrary,
    individuals are forward looking (Rational
    Expectations Hypothesis)

  • Rational Expectations Hypothesis (REH)
    individuals when making decisions use all
    relevant information, including knowledge of the
    structure of the economic system
  • Although the future is not fully predictable,
    agents' expectations are assumed not to be
    systematically biased.
  • Outcomes that are being forecasted do not differ
    systematically from the market equilibrium

  • Thinking of people as having rational
    expectations had major implications, all highly
    damaging to Keynesian macroeconomics
  • Policy Ineffectiveness Proposition (Sargent) If
    the Fed attempts to reduce inflation through an
    expansionary monetary policy, the economic agents
    will anticipate the effects of this change of
    policy and raise their inflationary expectations
    accordingly (according to the NCE only
    unanticipated changes in money affect output)

  • Disinflation policies According to the macro
    models based on adaptive expectations,
    disinflationa decrease in inflationcan be
    obtained only at the cost of higher unemployment
  • pt ? pt-1 ? a (ut ? un)
  • According to Lucas and Sargent, on the contrary,
    it is unrealistic to assume that wage setters
    would not consider changes in policy when forming
    their expectations
  • If wage setters can be convinced that inflation
    is indeed going to be lower than in the past,
    they decrease immediately their expectations of
    inflation, which would in turn reduce actual
    inflation, without the need for a change in the
    unemployment rate

  • The essential ingredient of successful
    disinflation, according to the New Classical
    Economists, is credibility of monetary policythe
    belief by wage setters that the central bank is
    truly committed to reducing inflation

  • The New Keynesian Economics
  • The new Keynesians are a group of researchers
    working on the macroeconomic implications of
    imperfections in different markets (e.g.
    imperfect information and incomplete markets)
  • According to the new Keynesians such phenomena
    as the persistence of unemployment and credit
    rationing are inconsistent with the standard
    microeconomic theory
  • Contrary to the NCE, the New Keynesians maintain
    therefore that microeconomic theory should be
    adapted in order to tackle macroeconomic problems

  • Some topics
  • Efficiency wage models are based on the
    hypotheses that i) there is imperfect
    information about the characteristics of the
    workers ii) the actions of the workers cannot be
    adequately monitored
  • It can be demonstrated that the quality of the
    labour force and its productivity increases (and
    conversely labour turnover decreases) with an
    increase in the wage
  • In other words, the wage that maximizes the
    firms profits need not to fall to market
    clearing levels

  • Credit rationing
  • Credit rationing is a situation in which the
    suppliers of capital (lenders) do not raise
    interest rates in the presence of an excess
    demand for capital
  • Reason increasing interest rates may lower the
    expected return to the supplier of capital,
    either because an adverse selection effect (the
    mix of applicants changes adversely) or because
    a moral hazard effect (borrowers are induced to
    take riskier actions)

  • Nominal rigidities
  • Stanley Fischer and John Taylor emphasized the
    presence of nominal rigidities, or the fact that
    many wages and prices cannot be immediately
    readjusted when there is a change in policy (as a
    consequence of medium-long term contracts)
  • Contrary to Lucas analysis of disinflation,
    therefore, a rapid disinflation would cause an
    increase in unemployment even if the rational
    expectations hypothesis applies

  • Common beliefs
  • Most macroeconomists agree that
  • -In the short run, shifts in aggregate demand
    affect output
  • -In the medium run, output returns to the natural
  • -In the long run, capital accumulation and the
    rate of technological progress are the main
    factors that determine the evolution of the level
    of output
  • -Monetary policy affects output in the short run,
    but not in the medium run or the long run
  • -Fiscal policy has short-run, medium-run, and
    long-run effects on output

  • Some of the disagreements involve
  • The length of the short run, the period of time
    over which aggregate demand affects output
  • The role of policy those who believe that output
    returns quickly to the natural level advocate the
    use of tight rules on both fiscal and monetary
    policy. Those who believe that the adjustment is
    slow prefer more flexible stabilization policies

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