Abstract
Having come to the end of theoretical preparation, it is possible in this and the following chapter to appreciate monetary and fiscal policy proposals of new classical macroeconomics. The starting point is the Phillips curve provided by Milton Friedman. Two implicit and arbitrary (i.e. non-abstracted) assumptions are revealed in Chap. 4: they are, first, an asymmetrical information dominating on both sides of labour market; and, second, a different flexibility of prices and wages. In order to scrutinize the effects of these presumptions, the Phillips story unfolds on a different set of assumptions. The new classical Phillips curve is introduced as a later development of this intermediate state. By analysing the islands of Lucas and on the ground of the Keynesian critique, the exact circumstances are identified and separated under which discretional monetary policy can or cannot be effective. The business cycle theory is also reviewed and, considering its assumptions and consistency, it is argued that not only unexpected policy interventions can be effective if the possibility of multi-period (non-white-noise) business cycles is postulated.
Pursuit of the image then prevents pursuit of the reality
(John Kenneth Galbraith: The new industrial state)
The world loves to be deceived
(Petronius)
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Notes
- 1.
It has to be stressed again that REH and new classical macroeconomics do not constitute an inseparable unit.
- 2.
We have to bear in mind that the new classical conception of labour market (according to which, both sides, i.e. both employers and labour unions, make all-out efforts to achieve the labour market equilibrium and, through this, maximal output) already included the signs to present the economic policy passivity as a behavioural norm.
- 3.
“What is the consequence of a government intervention in economy if it enhances government spending financed by money issuance to boost employment and to lower unemployment below its natural rate? […] this intervention is predestined to fail.” (Mátyás 1984)
- 4.
It seems to be very probable if we recall the remarks of Prof. Mátyás on the surprise supply function given by Lucas: “Government […] could exert an influence on the level of employment and production only if it was capable of moving the actual price level from the level expected by the public.” (Mátyás 1984)
- 5.
Mentioning his surname refers to Milton Friedman in the followings.
- 6.
It is exactly the characteristic that was highlighted by one of the most cunning definitions of the Phillips curve. According to it, “In some cases prices and wages were assumed to be mechanically adjusted to the level of excess supply in each market [viz. in commodity and labour market], such that price and wage inflation was a decreasing function of the rate of unemployment: the so-called Phillips curve.” (KVA 1995)
- 7.
As we will see, the only problem is that expectation-based decisions are attributed only to employees, while employers are assumed to determine employment (i.e. their demand for labour) considering actual real wage. However, it has to be stressed that considering expectations does not mean that employees enhance their labour supply expecting an increase in their real wage–the mechanism works in the opposite direction. It is a deviation from the expected dynamics that triggers the effects.
- 8.
Even if we lost the explanation that traces the rise in prices back to wage (and cost) dynamics, which was a characteristic element in the theory of Keynes. For Keynes, inflation, after all, was cost-push inflation, meaning that the increase in the price level triggered by the expanded demand manifests itself through a rise in (labour) costs. For the sake of trustworthiness of the history of economic thought, it should also be mentioned that distinguishing demand-pull and cost-push inflation is not a relevant aspect as far as the theory of Keynes is considered.
- 9.
The contrast, however, is not completely appropriate, since Keynes never investigated the macroeconomic effects of (disappointment of) inflation expectations.
- 10.
The General theory of Keynes was published in 1936, while the (only) Hungarian edition in 1965. If an economist takes the trouble to skim through the home papers in economics from these times onwards, he will realize that Keynes was almost completely ignored by the Hungarian authors. However, this confusing situation is easy to explain: Keynes could add only a few novel theses on the theory of centrally planned economies to those already known in Eastern Europe thanks to Marx. It is so very true that the history of economic thought is segmented in Marxian terms so that Prof. Mátyás (1963) distinguishes only two phases, a pre- and a post-Marxian stage (the latter embraces the theory of Keynes). Moreover, Keynes was highly criticized for abandoning the labour theory of value. Sardoni (1986) suggests various aspects of similarity between Keynes and Marx (while deploying a vast literature). He mentions, for example, that Keynes explicitly cited Marx in the previous drafts of his General theory (the final version contains only three, highly unimportant citations). The resemblance and parallelisms these two theories bear impel some authors to draw rather bizarre conclusions sometimes. For instance, Brandis (1985) highlights that Marx died in the year (1883) in which Keynes was born and, moreover, mentions the fact that both Keynes and Adam Smith were born on the same day of the year (5th July). On these grounds, he infers that the faith in reincarnation may not be an ungrounded assumption. Perhaps Alexander (1940) summarizes the most clearly. Although Keynes (1936) underlined that followers of (neo)classical economics were expected by him to fluctuate between a belief that the General theory was simply wrong and another belief that it had nothing new to say, he completely ignored those with a background pertaining to Marxian theory. They were pretty sure, since Keynes promised nothing new to them. Undoubtedly, the theory of Keynes was radically new to the British academic circles of the 1930s. “The Keynesian system is not only thoroughly consistent with the Marxian but also supplements it at certain critical points.” (Alexander 1940) Of course, Keynes did not copy Marx–it is interesting, for example, that, over and above Keynes (and nearly at the same time) Michał Kalecki (1935) could also reveal the need for countercyclical economic policies (for further details, see Vigvári 2008).
- 11.
It is more complicated when the expansion of productive capacities is not precluded either. The relation between inflation and unemployment is more sophisticated in a case like this. It should not be forgotten either that Keynes, on longer time-horizons, attributed higher importance to technological change in the determination of price dynamics and did not preclude even a drop in prices. The link between prices and demand becomes clearer if it is also considered that Keynes’ (1936) analyses were performed assuming a given (i.e. unchanging) set of equipments.
- 12.
To do this, we are required only to phrase the arbitrary assumption that the contracts leading to the temporary stickiness of prices in labour and commodity markets have different maturity dates.
- 13.
Referring to money illusion does not save the reasoning of Friedman, since he emphatically talks about employment conditions prevailing at former nominal wages. If nominal wages do not change, employees might even fall victim to money illusion (that is, expect former price dynamics to proceed), real wage as they perceive does not exceed the former level. Unemployment, therefore, does in fact exist and, in this case, its existence is brought about by, insufficient aggregate demand.
- 14.
It is a special characteristic that, in the original Friedmanian conception of the Phillips curve, the central bank was able to generate additional inflation so that it was known only to producers, while it could remain unknown to the mass of employees for a long time. A further oddity replaces it in this new classically inspired version of the Phillips curve, since, now, central bank can boost inflation with unchanged relative prices. One can hardly imagine an inflationary process that keeps relative prices intact (of course, this is mostly an empirical question).
- 15.
Edmund S. Phelps, professor of Columbia University (New York, NY), Nobel laureate of 2006. Júlia Király (1998) labelled Lucas’ Nobel prize as “overdue”, that is highly true for Phelps, since his grandiose theories, in spite of the Prize, lost much of their prior economic relevance. It is also interesting that Phelps has undertaken a significant role in prompting Lucas, and, in turn, Lucas received his Nobel prize in 1995. Phelps was awarded the highest scientific award (undeservedly) late with regard not only to the evolution of economic theory but his own career. Perhaps it is the most interesting question as to the theory of Phelps whether he should be classified as a representative of mainstream economics. On the scientific program of strengthening the microfoundations and on the influence of Phelps on the attitude of mainstream economics, see Howitt (2007). It has been pointed out that Phelps, just like Friedman, contributed to achievements in economic theory through reforming the central doctrines of mainstream economics (Grey 2002; KVA 2006). However, there is talk about a challenge to mainstream theory and about serious contradictions (e.g. Heckman 2008).
- 16.
There was consensus in the evolution of high theory as to the fundamental impotency of monetary policy in enhancing real economic performance. Keynes demonstrated it via the case of liquidity trap, while monetarists argued for this inefficiency on various theoretical grounds. For Keynes, the central bank can exert an influence on the interest-rate-dependent part of aggregate demand through affecting the rate of interest–however, this potential may be constrained by a liquidity trap and, moreover, the marginal efficiency of capital may occasionally collapse to such an extent that it cannot be compensated by any drops in the rate of interest. We can hardly find another thesis in which the antagonistic economic theories could similarly agree. Theorem of (persistent) impotency of monetary policy can, with reason, be regarded as an element (and manifestation) of an economic policy consensus. The significance of this common point cannot be overstated, however, literature still ignores this problem. For a bracing exemption, see Fischer (1977). It is obvious that arguments of Keynes with regard to monetary policy had an important role in stressing the efficiency of fiscal policy.
- 17.
That’s why it cannot be said that any countercyclical monetary policy intervention would have been needed in the theory of Friedman. For him, the ultimate question was what happens when monetary policy tries to dislocate real economy from the natural level of unemployment and output. Strictly speaking, it is growth-enhancement and not following of countercyclical purposes. Since, as Friedman argued, monetary policy is not capable of stimulating real economy in the long-run, dislodging it from the natural level, the outcome of such an attempt will be a policy-generated business cycle. The need for a countercyclical monetary policy appears only in new classical macroeconomics for the first time through postulating cycles defined as white noises. The problem to be investigated considerably cuts the relevancy and merits of Friedman’s theory, since he scrutinized an issue (“Is monetary policy capable of following long-term growth purposes?”) that had been already answered consistently by high theory even before the time of Friedman (“No, it is not.”) and he could only underline this answer. Is it a scientific achievement if someone demonstrates again (true, along different lines) that the dinosaurs died off?
- 18.
In which employers perceive price dynamics to be true all along.
- 19.
One could state that there is a relation between unemployment and the error of inflation expectations–but this option is preserved for the new classical Phillips curve (though, undoubtedly, that could be applied properly just like in this case). Later, the difference between the change in the rate of inflation and the disappointment (i.e. the error) in inflation expectations will be highlighted (with particular attention to some cases when they are equivalent).
- 20.
In the more sophisticated words of Shaw, even if an absolute price level has a role in determining unemployment, the relation (that, hence, indicates a direct relationship with the original concept of the Phillips curve) is at best temporary (Shaw 1984).
- 21.
If this line of reasoning was followed, we would not be allowed to refer to money illusion, that is, to the evaluation problems from perceiving changes in price level with an undue extent of correctness.
- 22.
Moreover, we ignored the circumstance up to now how a central bank could generate prices that change in a completely unexpected way.
- 23.
Considering this characteristic, the theory was labelled with the ever-recurrent adjective “accelerationist” (cf. Taylor 1979).
- 24.
The scope of general equilibrium analysis still seems to be unclarified in the system of economic theories. On technical grounds, it is reckoned to microeconomics, though the purport is not to analyze the dynamics of single markets or the behaviour of individual consumers or producers–microeconomics can deal with this problem without general equilibrium theory. Rather, general equilibrium analysis could be the prolegomena for a systematic neoclassical-mainstream macro-theory (as we have seen, these models sometimes quite directly rely on the Walrasian order of things); however, mainstream economics tries not to reveal this relationship. Stressing the general equilibrium analysis deserves attention for didactical purposes as well (either as settling of courses in microeconomics or as an introduction to macroeconomics), since it is always the missing link that could place macroeconomics to microfoundations. At the start of macroeconomic courses, the Keynesian invention is often mentioned, according to which macro-level investigations need special aspect and specific concepts, and even the parable is told stressing that micro- and macro-level rationality is something radically different (economic decisions being rational in micro-terms are not necessarily expected to be rational at an aggregate level–if all the firms cut wages, it can hardly resolve but deepens a recession). Then, after all, we use models that root in the neoclassical tradition.
- 25.
If we attach considerable importance to the microfoundations in the evolution of mainstream economics, labelling Phelps as a mainstream theorist does not seem to be complicated anymore. The Phillips curve he elaborated has definite microfoundations.
- 26.
Whether building a macro-theory on microeconomic axioms is necessarily undermined by the critique DSM-theorem exerted is another important issue. In other words: is the validity of all micro-founded macro-theory constrained by the DSM-theorem?
- 27.
Even if the success of this learning process may be doubted on grounds of discussion in Chap. 2. Some aspects of the difficulties of the learning process will be investigated in detail when reviewing the systematic and random components of a monetary policy rule.
- 28.
It has to be mentioned that inconsistencies are sometimes found in the REH literature, that is, it is not clear whether authors talk about monetary or a(n) (general) economic policy (cf. e.g. Brimmer and Sinai 1981).
- 29.
Weeks (1989) stresses that new classical macroeconomics, by emphasizing the inefficacy of systematic changes of the money supply, raised the banner of neutrality of money as well.
- 30.
The debate indeed focused on whether the view is correct that only unexpected effects are capable of dislocating the equilibrium temporarily (this view is labelled as LSW-theory after its elaborators, Lucas, Sargent and Wallace) or the short-run potency of anticipated monetary policy steps must be admitted as well, occasioned by the limited flexibility of prices–as a footnote, this view is equivalent to assuming price dynamics to be dependent on past path of changes in prices (cf. Gordon 1979).
- 31.
Samuelson’s model proved to be flexibly extended, since a model specified on two overlapping generations can be easily expanded to include a third age group (it is so true that Samuelson’s model had already been built from three overlapping generations and only Lucas simplified the setting to two clusters) making it possible to investigate and interpret investment in human capital, which seems to be its most beneficial characteristic for Júlia Király (2005). Moreover, one can easily introduce capital in addition to labour force, so capital investment cycles can be also studied in this modified version of the initial model. Of course, the original model of Samuelson was directed at purposes other than the goals at which it was aimed later by Lucas: Samuelson’s main interest was modelling interest rate dynamics.
- 32.
The single-commodity character of the economy is completely evident here as well, hinted slightly by Lucas.
- 33.
Manifestations of the evolutionary logic in economic theories sometimes quite directly adhere to the Darwinian theory of evolution. There are models in which entities (e.g. trading rules; Hirabayashi et al. 2009; Lin et al. 2007) create new generations. The so-called fitness-function describes the viability of these entities: those who are the fittest have the highest chance to create successors. A successor inherits the genes from its parents, but mutation is in the game, i.e. any new generation is going to differ from the ancestors somehow. Researchers use this technique based on the so-called genetic algorithms even to solve highly interesting and specific searching and optimization problems (e.g. Gruca and Klemz 2003).
- 34.
Of course, it has to be admitted that these agent-based models help us take a critical view on mainstream theory and models. As new classical macroeconomics also emerged with an explicit intention to build solid microfoundations, it may arouse suspicion if a school with a strong desire to differ fundamentally from new classicals talks about the need for microfoundations as well. However, when the underlying philosophy of agent-based models is thoroughly scrutinized, the difference between bottom-up (agent-based models) and top-down (mainstream economics) conceptualizing aspects becomes clear itself immediately. Agent-based models put light on the essence of micro-founding efforts of new classical macroeconomics, according to which economists are building top-down, i.e. they postulate a macro-structure in the beginning (define the system as a system), and try to trace some components of the macro-structure back to certain (abstract and presumed) characteristics of agents (cf. Oeffner 2008). The monetarist way of micro-founding is confined only to creating a market from a large number of agents that are completely identical. The Phillips curve (of Friedman and Lucas) is an outstanding example, where market mechanisms are deduced from the postulated behaviour of a multiplied average individual. In such a case, it is in fact indifferent whether the behaviour of only one agent or that of many is scrutinized. It is not hard to realize that the shape of the Phillips curve can be explained well on the basis of the behaviour of only one agent.
- 35.
The problem Lucas scrutinized had been something different from that identified by Júlia Király as the key question. The author writes that “[Lucas] regarded markets of an economy as isolated islands that can get pieces of information available for all the islands (say, dynamics of money supply) but do not have detailed knowledge on each other. This assumption seems to be acceptable even today, in the age of »perfect information« if we consider the fact that while aggregate data are available almost free, one must pay such a high price for special data that it is not worth buying or it cannot be purchased at all.” (Király 1998). Rather, a precise phrasing of the problem can be given by saying that agents, although they know the price dynamics in their own markets, are not able to interpret them; and it is the less true that they posses more information about the aggregate level, since it is exactly the events happening in other markets (on other islands) about which agents know nothing. So, the analogy does not go on all fours.
- 36.
The word “utopia” is used in three senses at least. The compound of Greek origin was applied for the very first time by Thomas More as the name of the country he imagined. Its meaning grew richer afterwards as started appearing as the name of all kinds of envisaged countries and, simultaneously, became the generic term for literary works about such countries (Morton 1969).
- 37.
More, sharing in the current of Christian humanism, lived under the joint spell of Greek-Latin antiquity and Christianity at the same time. He was the son of an interesting era: there were vast debates, say, on if an angel could be at multiple places at the same time or she was bounded by the spatiotemporal constraints similarly to us. More perished on the block in requital for his consistency of principle and faith (for further details, see Chadwick 1993).
- 38.
For scientific socialism, More was one of the very first communist thinkers (cf. Mihalik and Szigeti 1984). The idea is that perhaps Plato was the only one preceding him in these efforts (Morton 1969). More’s communism is highly controversial. Some authors deny that More can be discredited by communism even because of his Christianity and his views charged to be pre-communist (e.g. the lack of private property, strict rules as to dressing, interpreting society as a huge family) rhyme rather to cloistered life. Some of his assertions were quite simply meant to be jokes (Nigg 1979).
- 39.
It is interesting that Weber (1934) relates the highest level of (actually manifested) economic rationality also to bourgeoisie.
- 40.
It is wise to refer to information set \( {I}_t \) as the information underlying expectations for period t.
- 41.
At this point in the discussion, it has to be recalled that local prices can be deviated from the expected value of the general price level by both a global price shock and a relative price shock in any combination. A genuine problem, therefore, is that the actual effect is a mixture of these factors.
- 42.
Begg (1982) phrases rather loosely by saying this: “[…] no matter how we define the rest of the model and no matter which systematic parts of policy rules are altered, the effect on the path of real output will be nil.” This is not explained by the restoration of PFH. This statement is completely wrong since it precludes even the temporary effectiveness of surprises.
- 43.
- 44.
Stressing of exogenity will become really important apropos of supply side applications of fiscal policy, where we are going to realize that the exogenous nature of natural level of output is not an axiomatic element of the theory.
- 45.
Moreover, it naturally follows from all of these (that is, from the rationality of expectations) that systematic, therefore completely predictable monetary policy steps are also ineffective, since known rules cannot generate surprise-inflation.
- 46.
Following Lucas, Blinder and Fischer (1979) also stress that surprise-inflation is a white noise.
- 47.
It is obviously not independent of the debate that is, in fact, about faiths. According to it, some economists evidently regard the economy as an equilibrium system, even if a given macroeconomic unit departs from this state again and again; others regard these swings as the evident lack of equilibrium (cf. Király 2000). However, it seems to be a different case, since Sargent and Wallace do not talk about macroeconomies moving away from the state of (general) equilibrium from time to time but rather that equilibrium can emerge and can be achieved only accidentally, thanks to random effects.
- 48.
Note that the neutrality of money was established in the false dichotomy model so that money got thrown on the system only after real equilibrium had already been found–in other words, money had no role in setting the equilibrium.
- 49.
As an instance, this phrase can be referred to both schools: “[…] real variables can diverge from their natural values only if agents make mistakes [when forming expectations].” (Hahn 1980).
- 50.
It must be noted that Keynes himself was also sceptical about the efficacy of monetary policy. For him, central bank stimulates the interest-rate-dependent part of aggregate demand through controlling the rate of interest. However, this potency could be limited by the liquidity trap and by the fact that the marginal efficiency of capital sometimes collapses to an extent that may not be offset by drops in the rate of interest. This is the reason why Keynes put his main emphasis on fiscal policy.
- 51.
Easing these requirements led to a modified version of LSW-theory, discussed below.
- 52.
It is very important to stress that these shocks are outside of the territory of policy. It turned out to be significant, first of all, in relation to the new classical views on the equilibrium of macro-systems. Considering these questions, we might realize that even a completely systematic monetary policy rule (one with no random elements) cannot guarantee a permanent macroeconomic equilibrium. Under stochastic conditions, where contingencies also contribute to the disappointment in expectations, equilibrium becomes completely accidental.
- 53.
It is equally true for open and closed economies. In case of open national economies with fully convertible currencies, the big picture becomes more complicated due to international capital flows which break money in circulation off the monetary base even farther.
- 54.
Each monetary aggregate fulfils different functions of money. Hence, \( {M}_1 \) serves transactions primarily, while \( {M}_2 \) and \( {M}_3 \) tend to accentuate the treasuring function (Vigvári 2008).
- 55.
Using conditional is justified here by the fact that we are free to assume this: market participants are not content with forming expectations on the basis of \( {M}_0 \) only.
- 56.
It will become clear soon that this problem cannot be resolved even by incorporating further explanatory variables over and above the monetary aggregates, as Barro (1977) did.
- 57.
In formal terms, this means that divergences of real output from the natural level are not serially correlated.
- 58.
We might remember that the growth rate of idle money held by the members of the older generation was determined by a stochastic variable x; cf. Eq. (4.1).
- 59.
In his analysis, Fischer studied only the problems of stickiness caused by wage agreements–although he mentioned that other forms of contracts can trigger similar effects.
- 60.
These contracts require special conditions to emerge–as Fischer also stressed. It is important to note that in terms of stabilizing the variance of real wages, these multi-period contracts are not the best option to follow. This goal can be achieved more easily by agreements concluded for shorter periods. However, we have to bear in mind the considerable costs of recurrent wage negotiations and agreements, leading to longer-run wage contracts.
- 61.
To draw the analogy between these two theories, what we need to do is to regard the inflation expected by the employees as announced by the monetary authority (and the implementation of which it adheres to or not).
- 62.
These new beliefs and opinions ensure biasedness. Without them, expectations would be rational and predictions would be unbiased (so, there would be no transition period either), i.e. the public would know the rules followed by the new monetary policy regime from the very beginning.
- 63.
Bear in mind the lessons from Chap. 2 that helped us realizing that there is no way to find the relevant model in a stochastic environment. Since prediction errors may occur even if this relevant model is known, any modeller walks randomly among the different states and phases of his model, as he cannot judge whether these errors are due to contingencies or to the misspecification of the model. Thus Taylor’s reasoning is dubious.
- 64.
A different case (leading to the same conclusions) is when the public tries to approximate mean inflation, chosen by the new policy, through estimations based on various factors (even on the personal character of new policy makers).
- 65.
This welfare loss is not caused by the increase in the variance of the error per se. Phillips curve is generally assumed to be convex, therefore it is true that although the expected value of the unemployment-dependent inflation is zero, a greater variance of prediction errors results in a higher expected level of unemployment because of the Jensen inequality–and the welfare loss is its direct consequence.
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Galbács, P. (2015). Monetary Policy in the New Classical Framework. In: The Theory of New Classical Macroeconomics. Contributions to Economics. Springer, Cham. https://doi.org/10.1007/978-3-319-17578-2_4
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