Download Friedman and the Natural Rate Theory

Ch. 15: Expectations
Theory and the Economy
James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts University
©2005 South-Western Publishing, A Division of Thomson Learning
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Phillips Curve Analysis
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Original Phillips Curve: suggested an
inverse relationship between wage inflation
and the unemployment rate.
Samuelson and Solow’s Phillips Curve:
suggested an inverse relationship between
price inflation and the unemployment rate.
Higher wage inflation means lower
unemployment; lower wage inflation means
lower unemployment.
High unemployment and high inflation
unlikely.
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Theoretical Explanations
for the Phillips Curve
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Early explanations
focused on the state
of the labor market
given changes in
aggregate demand.
Businesses must
offer higher wages to
obtain additional
workers when
unemployment is
low.
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Exhibit 1: The Original Phillips Curve
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Exhibit 2: The Phillips Curve and a
Menu of Choices
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Are There Two Phillips
Curves?
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Economists began to question the Phillips
curve in the 1970s and early 80s.
The periods 1961 – 1969 and 1976 - 1979,
illustrate the Phillips curve.
The period 1970-2003 does not as a whole
depict the tradeoff between inflation and
unemployment.
The existence of stagflation implies that a
tradeoff between inflation and
unemployment may not always exist.
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Exhibit 3: The Diagram That Raises
Questions: Inflation and
Unemployment 1961–2003
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Friedman and the Natural
Rate Theory
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There are two Phillips Curves, not one.
There is a Short Run Phillips Curve,
and a Long Run Phillips Curve.
There is a tradeoff between inflation
and unemployment in the Short Run,
but not in the Long Run.
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Friedman’s Natural Rate
Theory
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Friedman Natural Rate Theory: in the long run,
unemployment is at its natural rate. The long-run
Phillips curve is vertical at the natural rate.
Adaptive Expectations: expectations that
individuals form from past experience and modify
slowly.
In the long run, the economy returns to its natural
rate of unemployment and the only reason it moved
away from the natural unemployment rate in the
first place was because workers were “fooled” (in
the short run) into thinking inflation was lower than
it really was.
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Exhibit 4: Short-Run and Long-Run
Phillips Curves
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Exhibit 5: Mechanics of the
Friedman Natural Rate Theory
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Self-Test
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What condition must exist for the Phillips
curve to present policymakers with a
permanent menu of choices between
inflation and unemployment?
Is there a tradeoff between inflation and
unemployment? Explain your answer.
The Friedman natural Rate Theory is
sometimes called the “fooling” theory. Who
is being fooled and what are they being
fooled about?
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Rational Expectations and
New Classical Theory
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Rational Expectations:
expectations that individuals
form based on past
experience and on their
predictions about the
effects of present and
future policy actions and
events.
Lucas combined the Natural
Rate Theory with Rational
Expectations
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Rational Expectations
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Friedman Natural Rate
Theory: natural rate
theory built on adaptive
expectations.
New Classical Theory:
natural rate theory built on
rational expectations
– Expectations are formed
rationally
– Wages and prices are
flexible
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Do People Anticipate
Policy?
Not all persons
need to anticipate
policy. As long as
some do, the
consequences may
be the same as if all
persons do.
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Exhibit 6: Rational
Expectations in an AD-AS
Framework
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Policy Ineffectiveness
Proposition
If:
A policy change is correctly anticipated;
2. Individuals form their expectations
rationally; and,
3. Wages and prices are flexible.
Then:
Neither fiscal nor monetary policy is
effective in meeting macroeconomic
goals.
1.
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Exhibit 7: The Short-Run Response to an
Aggregate Demand-Increasing Policy
That is Less Expansionary Than
Anticipated (in the New Classical
Theory)
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How to Fall into a Recession
Without Really Trying
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If government says it will do X but instead it
continues to do Y, the people will see
through the charade: the equation in their
heads will read “Say X=Do Y.”
If the Fed says it is going to do X, then it
had better do X, because if it doesn’t, then
the next time it says it is going to do X, no
one will believe it, and the economy may fall
into a recession as a consequence.
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Self-Test
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Does the policy ineffectiveness proposition
(PIP) always hold?
When policy is unanticipated, what
difference is there between the natural
rate theory built on adaptive expectations
and the natural rate theory built on
rational expectations?
If expectations are formed rationally, does
it matter whether policy is unanticipated,
anticipated correctly, or anticipated
incorrectly? Explain your answer.
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New Keynesians and
Rational Expectations
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New classical theory assumes complete
flexibility of wages and prices.
New Keynesian rational expectations theory
assumes rational expectations is a
reasonable characterization of how
expectations are formed, but drops the
assumption of complete wage and price
flexibility.
Long-term labor contracts often prevent
wages and prices from fully adjusting to
changes in the anticipated price level.
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Exhibit 8: The Short-Run Response to
Aggregate Demand-Increasing Policy
(in the New Keynesian Theory)
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Looking at Things from the Supply
Side: Real Business Cycle Theorists
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Changes on the supply side of the economy can
lead to changes in Real GDP and
unemployment.
A decrease in Real GDP can be brought about
by a major supply-side change that reduces the
capacity of the economy to produce.
What looks like a contraction of Real GDP
originating on the demand side of the economy
can be, in essence, the effect of what has
happened on the supply side.
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Exhibit 9: Real Business Cycle
Theory
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Real Business Cycle
Theory
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It is easy to confuse a
demand-induced decline in
Real GDP with a supply-side
induced decline in Real GDP.
The cause-effect analysis of
a contraction in Real GDP
would be turned upside
down. Changes in the
money supply may be an
effect of a contraction in Real
GDP and not its cause.
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Self-Test
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The Wall Street Journal reports that the
money supply has recently declined. Is
this consistent with a demand-induced
or supply-induced business cycle, or
both? Explain your answer.
How are New Keynesians who believe
people hold rational expectations
different from new classical economists
who believe people hold rational
expectations?
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Coming Up (Ch. 16): Economic
Growth: Resources, Technology and
Ideas
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