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Keynes Friedman

"The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.

Derivation of Beveridge curveUnemployment rate = uφ = exogenous rate of job destructionLabor market “tightness” = θ = v/uUnemployed workers find jobs at rate of α = α(θ)Steady state unemployment when flows are in equilibrium:

(1)

which yields a negative relationship between u and v.

2

*( ) ( */ *)

uv u

Okun’s Law over time

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3

4

5

6

7

8

9

10

11

-.06

-.04

-.02

.00

.02

.04

.06

.08

.10

1980 1985 1990 1995 2000 2005 2010

Unemployment rate (left scale)(Potential-actual)/ Potential GDP (right scale)

Δu = (8/16)(Δ %gap)= ½ (Δ%gap)

Final steps toward full short-run model

4

We will develop full AS-AD model as presented in Mankiw Chapter 14. We will develop model on Friday and show its properties.

Equations of model:

1. IS Yt = Y* - α (rt –r*) + μG + εt

2. Cost of capital: rt = it – π e t + risk premium

3. Phillips curve: π t = π e t + φ(Yt - Y* ) + ξt

4. Inflation expectations: π e t = π t-1

5. Monetary policy (Taylor) i t = πt + θ π (πt - π*) +θY (Yt - Y* )

We did (1) in IS-LM section.We did cost of capital (2) in investment section.We do (3) Phillips curve today (but substitute Y for u).We discuss (4) expectations briefly.We discuss Taylor rule (5) on Friday and in pset.

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Inflation’s history in the US

50

100

150

200250

350

500

1000

15002000

00 25 50 75 00 25 50 75 00

CPI Price index of GDP

Pri

ce (

1865

-191

4 =

100

)

Gold-silverstandardperiod

6

Inflation Since WW II in the US

-.04

.00

.04

.08

.12

.16

45 50 55 60 65 70 75 80 85 90 95 00 05

Rate of CPI inflation

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How do we measure price indexes?

Consumer price index:- Traditionally a Laspeyres price index (fixed weight

index using early prices)- Uses the “matched model” approach- BLS has introduced an experimental index – the

“chain CPI” – which is a superlative Törnqvist index. Grows more slowly than traditional CPI

GDP price index- This is a Fisher (superlative) index

“Core Inflation”- removes volatile food and energy and is central

target for monetary policy

Why do we care about inflation?

Like temperature, we care mainly about the extremes:

Hyperinflation (> 50% a month)

Deflation (< 0)

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What are costs of inflation?

• Redistribution: inflation redistributes wealth from creditors to debtors (mortgages, pensions).

• Inefficiencies of inflation: shoe leather, menu costs, taxes,...

• Distinguish anticipated from unanticipated inflation (ex ante v. ex post real interest rates)

• Overall, costs appear relatively small at low inflation rates.

• Hyperinflation can destroy price mechanism• Deflation can produce low-level equilibrium• Fed’s “comfort zone” is 1 to 2 percent per year

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The Expectations -Augmented Phillips Curve

Inflation determined by labor/product market tightness and expected inflation.

Have tradeoff between inflation and unemployment in short run, but no tradeoff in long run (Phelps-Friedman theory)

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The short-run P.C.

Graph from Economic Report of the President 1969

This was relationship that led Keynesian to believe that P.C. was a good explanation for inflation (1960s)

1. (πe)

12

0

1

2

3

4

5

6

2 3 4 5 6 7 8

Unemployment rate

CP

I in

flatio

n ra

te

1961

1969

Early Phillips Curve

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Collapse of short-run P.C.

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2

4

6

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10

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14

2 3 4 5 6 7 8 9 10

U

Pi

1961

1995

1980 This was relationship that led many new classical economists to conclude that Keynesian theories were “fatally flawed” (Lucas and Sargent. 1970s)

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Mainstream 3-equation inflation model

(1) π(t) = [w(t)-A(t)] + επ(t)

(2) w(t) = πe(t) - β[u(t) - u*] + εw(t)

(3) πe(t) = π(t-1)

Endogenous variablesπ = rate of price inflationw = rate of wage inflationw-A = growth rate of unit labor costsπe = expected rate of inflation (or similar concept)u* = natural rate

Exogenous variablesA = growth rate of average labor productivity (Q/L)u = actual unemployment rate (determined by policy and shocks)επ(t) and εw(t) = wage and price shocks (oil prices, exchange rates, globalization, decline of unions, immigration, etc...)t = time

[Note: (3) is backward looking rather than rational expectations.]

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Simplest 1-equation inflation modelSimplify price equation by assuming no shocks:

(1’) π(t) = w(t)

Substituting, we get:

(4) π(t) = π(t-1) - β[u(t) - u*]

(5) Δ π(t) = β[u(t) - u*]

which is the linear expectations-augmented P.C. model.

16u* = natural rate

π1 = π1e

SRPC1

Short-run Phillips curve

1

17u* = natural rate

π1 = π1e

Moving up short-run Phillips curve

1

2

SRPC1,2

π2

18u* = natural rate

π1 = π1e

Short-run Phillips curve shifts upward with higher inflation expectations

1

2π3

e =π2

SRPC1,2

SRPC3

19u* = natural rate

π1 = π1e

SRPC1,2

SRPC3

1

2

3π3 = π3

e

Now unemployment rate back to the natural rate

20u* = natural rate

π1 = π1e

SRPC1,2

LRPC

SRPC3

1

2

3π3

e =π2

u equals the natural rate in both periods 1 and 3, but the expected and actual inflation rates are higher in period 3.

This diagram shows the way that the SRPC shifts as expected inflation adjusts to higher rate.

Go back to the spiral curves and make sure you see why this theory predicts the clockwise loops.

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-6

-4

-2

0

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4

6

3 4 5 6 7 8 9 10

Unemployment rate

Inflat

ion

- Inf

lation

(t-1

)

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New synthesis of accelerationist PC

Rough estimate of natural rate for 1961-2005 = 6 percent Δ π(t) = β[u(t) - u*]

u* is u where Δ π(t) =0.

This was the new synthesis developed by Phelps and Friedman (1967-68). It now forms the basis of mainstream macro for large open economies.

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Summary onThe Expectations-Augmented Phillips Curve

• u and π are negatively related in short run

• no relation between u and π in the long run

• short-run PC adjusts up and down as economic agents adjust their inflation expectations to reality (combination of backward and forward looking expectations).

• Natural rate is u at which inflation tends neither to rise nor fall

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Friedman on Keynes

“Keynes's bequest to technical economics was strongly positive. His bequest to politics, in my opinion, was not. Yet I conjecture that his bequest to politics has had far more influence on the shape of today's world than his bequest to technical economics. In particular, it has contributed greatly to the proliferation of over-grown governments increasingly concerned with every phase of their citizens' daily lives.”

(“John Maynard Keynes.” Milton Friedman, Federal Reserve Bank of Richmond Economic Quarterly Volume 83/2 Spring 1997)

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Nobel citation on Friedman on Phillips curves

“Friedman has left his mark on yet another area of the scientific debate on the causes of inflation. This concerns the course of diffusion of wage and price rises. Friedman was the first to show that the prevalent assumption of a simple "trade-off" between unemployment and the rate of inflation only held temporarily as a transient phenomenon; in the long run (more than five years) there is no such "trade-off".

According to Friedman's theory, a level of unemployment which is held below a structural equilibrium level leads to a cumulative rate of price and wage increase, primarily because of the destabilizing role that expectations play. Present day formulations of wage and price determination are, in important respects, built on Friedman's hypotheses about the importance of inflationary expectations.”

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Capitalism and Freedom

"Historical evidence speaks with a single voice on the relation between political freedom and a free market. I know of no example in time or place of a society that has been marked by a large measure of political freedom, and that has not also used something comparable to a free market to organize the bulk of economic activity".

(Capitalism and Freedom, p. 9)

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Capitalism and Freedom

• Capitalism and freedom is a persuasive argument against government interferences with the market place.

• Are you in favor social security, building levees against hurricanes, restricting addictive drugs, regulating cigarettes, licensing of doctors, national parks, minimum wage, rent controls, environmental policy, free public schooling, keeping the Federal Reserve, drivers licenses?

• Friedman argues against each of these as both ineffective and as undesirable interferences with personal freedoms.

• Friedman is the most influential “academic scribbler” behind modern libertarian thinking.