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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 Center for the History of Political Economy Summer School June 2014 2 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 1 Center for the History of Political Economy Summer School June 2014 3 The Postwar International Monetary Order Bretton Woods Conference 1944 Center for the History of Political Economy Summer School June 2014 4 The Wartime Controlled Economy Center for the History of Political Economy Summer School June 2014 5 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] Center for the History of Political Economy Summer School June 2014 6 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] Center for the History of Political Economy Summer School June 2014 7 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) Center for the History of Political Economy Summer School June 2014 8 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) Center for the History of Political Economy Summer School June 2014 9 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 Center for the History of Political Economy Summer School June 2014 10 The Original Phillips Curve Center for the History of Political Economy Summer School June 2014 11 Estimation of the Phillips Curve Center for the History of Political Economy Summer School June 2014 12 Stability of the Phillips Curve Center for the History of Political Economy Summer School June 2014 13 Dynamics of the Phillips Curve - 1 Center for the History of Political Economy Summer School June 2014 14 Dynamics of the Phillips Curve - 2 w = –0.9w-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 Center for the History of Political Economy Summer School June 2014 15 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) Center for the History of Political Economy Summer School June 2014 16 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 Center for the History of Political Economy Summer School June 2014 17 The Phillips Curve Comes to America Paul Samuelson (1915-2009) Robert Solow (1926- ) Center for the History of Political Economy Summer School June 2014 18 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 Center for the History of Political Economy Summer School June 2014 19 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 Center for the History of Political Economy Summer School June 2014 20 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 Center for the History of Political Economy Summer School June 2014 21 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 Center for the History of Political Economy Summer School June 2014 22 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 Center for the History of Political Economy Summer School June 2014 23 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 Center for the History of Political Economy Summer School June 2014 24 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 Center for the History of Political Economy Summer School June 2014 25 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 Center for the History of Political Economy Summer School June 2014 26 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) Center for the History of Political Economy Summer School June 2014 27 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 Center for the History of Political Economy Summer School June 2014 28 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 Center for the History of Political Economy Summer School June 2014 29 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 Center for the History of Political Economy Summer School June 2014 30 Thanks The End Center for the History of Political Economy Summer School June 2014 31