The Postwar International Monetary Order

Economics 882 History of Modern Macroeconomics (Spring 2013,

Module 2) 1

History of Modern MacroeconomicsLecture 3.5. The Problem of Inflation

(1950-1970)

Kevin D. HooverDepartment of EconomicsDepartment of Philosophy

Center for the History of Political EconomyDuke University


Module 2) 2

Consumer Prices in the United States, 1774-2003

1

10

100

1000

Ind

ex (

1982

-84=

100)

Source: Historical Statis tics of the United States

Revolutionary War

War of 1812

Civil War

World War I

Great Depression

End of the Gold Standard

World War II

Beginning of Bretton Woods

End of Bretton Woods

Log Scale


Module 2) 3

Retail Prices in the United Kingdom 1770-2009

1

10

100

1000In

dex

198

7=10

0

Napoleonic Wars; suspension of gold

convertibility

Resumption of gold convertibility

World War I; suspension of gold standard

Reinstatement of gold standard

End of gold standard

World War II

End World War II; being Bretton Woods

End Bretton Woods


Module 2) 4

The Postwar International Monetary Order

Bretton Woods Conference 1944


Module 2) 5

The Wartime Controlled Economy


Module 2) 6

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]


Module 2) 7

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]


Module 2) 8

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)


Module 2) 9

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)


Module 2) 10

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


Module 2) 11

The Original Phillips Curve


Module 2) 12

Estimation of the Phillips Curve


Module 2) 13

Stability of the Phillips Curve


Module 2) 14

Dynamics of the Phillips Curve - 1


Module 2) 15

Dynamics of the Phillips Curve - 2

w = –0.9w-1 – 0.3 U-1 – 0.1[w + (–0.9 – 9.638U-1.394)]-1 +

0

1

2

3

2 2.2 2.4 2.6 2.8 3 3.2 3.4 3.6 3.8 4

Unemployment Rate

Rat

e of

Wag

e In

flat

ion


Module 2) 16

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)


Module 2) 17

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


Module 2) 18

The Phillips Curve Comes to America

Paul Samuelson (1915-2009) Robert Solow (1926- )


Module 2) 19

The U.S. Phillips Curve

Samuelson and Solow, “Analytical Aspects of Anti-Inflation Policy,” AER Papers and Proceedings 1960

Wage Inflation/Unemployment

Scatter

Price Inflation Phillips Curve


Module 2) 20

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


Module 2) 21

Reception of the Phillips Curve

Economics citations in JSTOR: Oldest (1959) in

comment on original Phillips paper

Non-economics citations: Total 912 Earliest 1971 in

Political Science journal

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


Module 2) 22

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


Module 2) 23

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 in long run – but an empirical discovery, not a point of principle

Specified for an environment with zero long-run inflation true for Phillips (but again contingent) false for Samuelson and Solow


Module 2) 24

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


Module 2) 25

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

theoretical paper vs. conversational, popular format

less visible journal not committed to free

market/monetarist program

Edmund Phelps (1933- ), Nobel Laureate 2006


Module 2) 26

Challenge of Explaining the Short-run Phillips Curve – 1

1. Expansionary monetary policy raises the inflation rate

2. Movement along original Phillips curve and ↓U

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 3. Phillips curve shifts over

time as workers adjust expectations to higher rate of inflation and ↑U to NRU

NRU

(1)

(2)

(2)

(3) (3)

U

p

Phillips Curve


Module 2) 27

Challenge of Explaining the Short-run Phillips Curve – 2

Asymmetry of information: Firms form correct expectations of inflation Workers form correct expectations only with a lag

Difference between long and short run: 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)


Module 2) 28

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


Module 2) 29

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


Module 2) 30

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


Module 2) 31

Thanks

The End

The Postwar International Monetary Order

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