Battles against Keynes

Milton Friedman and Monetarist

Chicago guys:
Stigler
Friedman
Galbraith
 Main Ideas

• Quantity Theory of Money: Money Matters

• Consumption: Permanent Income Hypothesis
• Monetarist Phillips Curve
• Negative Income Tax
 Quantity theory: MV=PQ

Keynes: “Some people seem to infer… that output and income can be raised by
increasing the quantity of money. But this is like trying to get fat by buying a larger
belt. In the United States today your belt is plenty big enough for your belly”
Why V=? If ∆M>0, why assume that people will spend the extra money?
∆V<0 might offset ∆M
Monetary Policy does not work directly through consumption but through interest
rates and investment
Friedman’s Car Registration Plate
 Keynesian
MV = PQ
MV = (QC+QI)
Prices are “sticky”
Investment suffers from “animal spirits.”
Consumption falls as the economy spirals downward.
 Keynesian

MV = (QC+QI+QG)

People begin to hoard money (“V” falls)

and may even become “fetishistic” in
their money-hoarding propensities.
 Just One Evidence

Keynes’s evidence: Great Depression Monetary Policy does not matter

Friedman’s evidence: Great Depression Monetary Policy fail
Where does money for fiscal spending come from?
Government spending should crowd-out private spending (C, I)!
 𝑀 . 𝑉 =𝑃 . 𝑄
Between 1929-1933: M decrease 1/3
Fiscal Policy: Keynesian View?
Monetary policy: Keynesian View?
 WHY Fed should not do any thing?

• Most monetarists do not advocate an activist monetary policy stabilization.

Instead, they advocate a policy of steady and slow money growth, at a rate
equal to the average growth of real output (Y). (2-3%)
• Economists do not know enough about monetary policy to manipulate it
wisely, so central bank might hurt the economy when it tries to fine-tune
because it cannot know the policy lag (recognition lag, impact lag…).
• The key to stable economic growth is a constant rate of increase in the
money supply
Keynesians vs Monetarists
 Permanent-Income Hypothesis

• Keynes: Consumption depends only on current income Y, C=C +MPC.Y

0

• Friedman: People experience random and temporary changes in their

incomes from year to year: Y=YP+YT (where YT- Transitory income), they can
use saving and borrowing to smooth consumption in response to transitory
changes in income, so C=αYP . [Franco Modigliani: C= αW+βY]
• Temporary Policy have little effect!
• A direct attach to Keynesian consumptionMPCFiscal Policy Multiplier
 Monetarist Phillips Curves

• The Phillips curve had become part of the Neoclassical synthesis, but
Milton Friedman (and Edmund Phelps) argued that the apparent trade-
off between unemployment and inflation would quickly vanish if policy
makers actually tried to exploit it.
• By the mid 1970s, the consensus was that there was no long-run trade
off between inflation and unemployment. The appearance of a trade-
off between inflation and unemployment was an illusion.
 Monetarist Phillips Curves

• In the short-run, if people have adaptive inflationary expectations,

there will be a temporary trade-off.
• If Fed try to peg unemployment rate under Natural rate of
unemployment (non-accelerating inflation rate of unemployment
– NAIRU), it will accelerate inflation
Monetarist Phillips Curves
 Volcker disinflation
Oct. 1979 Fed announced that it would shift from targeting a given level of
the short term interest rate to targeting growth rate of nominal money
 Friedman’s Negative Income Tax

• Negative Income tax: subsidy for low income level

• High marginal tax rate provide disincentive to work, negative marginal tax
rate provide more incentive for working Increase labor supply
 Consumption-Leisure Model

• C+L=, Labor Supply= so Consumption=Income=w()

• With income tax: Consumption=w(1-t)()
• When C<, t=t <0; C<, t=0 otherwise, t=t2>0
1
Consumption-Leisure Model
Earned Income Tax Credit (EITC)
Earned Income Tax Credit (EITC)
New Classical Macroeconomics
 Freshwater Economists

• University of Chicago: Robert Lucas

• University of Minnesota: Thomas Sargent
Saltwater Economists: mainly New Keynesian Economists at Harvard, MIT,
University of California, Berkeley;
 Main pillars

• Rational Expectation Hypothesis (REH)

• Efficient Financial Market Theory (EFMT)
 Assumptions
• Micro foundations and Walrasian general equilibrium approach to
Macroeconomic Theory
• All economic agents optimize continuously, i.e. subject to their
constraints, firms maximize profits and households maximize utility
• In taking optimizing decisions, agents take into account only relative
prices (do not suffer from money illusion)
• Agents able to exhaust all profitable opportunities, wages and prices
are flexible and markets continuously clear
 REH: Lucas Critique

• When trying to predict the effects of a major policy change, it could be very
misleading to take as given the relations estimated from past data

• Estimating from past data: . The only way to reduce inflation is to increase
unemployment
• If wage-setter could be convinced that inflation was indeed going to be lower than in
the past, they would decrease the expectation of inflation. This will reduce actual
inflation.
 REH: Lucas Critique

• Econometric models can not be used to estimate the effect of proposed

policy because of expectations, relationship between economic variable
change with policy change
• Application to Deficit spending: people would expect the long-term cost of
debt, they would save in order to prepare for future tax increase, so fiscal
policy has little effect. This is so-called Ricardian Equivalence.
 Rational Expectation Hypothesis

• On average economic agents correctly perceive economic variables. For

example, on average workers will accurately guess the inflation rate next period
and will act in such a way as to protect themselves from any adverse effects
(They do make errors, but they do make NO systematic errors )
• Rational individuals make efficient use of all the information available to them
• The universe exhibits stability over time: that the future can be inferred from
the past and the present. The model used to predict is the best available
 REH: A Simple model

• Let’s suppose we wish to forecast the rate of inflation p

• We start with the assumption that economic agents use any and all
information available to forecast next period’s inflation rate, which, it is
assumed, has one unique value
• If the forecast is unbiased then p = p* + u and E(p) = p*, where p is the
forecast value of inflation, p* is the actual value, and u is random error with
E(u) = 0 and is independent of p*
 REH: Critics

• Model assumes a unique p*; in the real world multiple p* may be possible and which p*
occurs is based on agents’ actions
• For example, the Fed announces a 5% target inflation rate, which is now 10%
• if people do not believe the Fed and expect 10% inflation, wage rise 10% and inflation is
10%
• If the Fed, however, cuts money growth to coincide with their target 5%, a recession
follows
• On the other hand, if the Fed credible, then the expected p* is 5% and wages and prices
rise by 5% and there is nor recession
• Thus, economic agents’ actions may determine p*
 REH: What kind of expectation we have?

• If inflation is low and stable, expectations are probably static

• If inflation is moderate and fluctuates slowly, expectations are probably
adaptive
• When shifts in inflation are clearly related to changes in monetary policy,
swift to occur, and large enough to seriously affect profitability,
expectations are probably rational
 Efficient Financial Market Theory

• Apply REH in financial market with a large number of buyer and seller
• Markets are the best determinants of accurate prices (market knows best),
prices represent the best estimate of risk
• The probability of an event happening is given by a normal distribution
(Gaussian Bell shape)
 Efficient Financial Market Theory

• Asset prices (stock prices) reflect all available information

• markets adjust immediately to new information
• prices incorporate expectations about future

• For example, the price of XYZ stock is $25, so value of $25 based on past
prices, profits, trading,…; forecasts about future profits, market share…; and
other relevant economic conditions
 Efficient Financial Market Theory
• IF stock market is efficient,
• THEN stock prices already reflect all relevant, available information
• SO, using the same info to predict future prices will not work

• if future stock prices were predictable… Expect price to rise tomorrow,

Then you buy it today so Price rises TODAY
• Stock price today reflects our expectations about future price
movements: a “random walk”

• It is impossible to “beat the market”

 IMPLICATIONS

• Picking stocks does not make any sense

• Rational and predictable fiscal and monetary policies does not have any
impact in economy
• Market decision and non-activist role of government