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The Managed Economy (1945-1975): The Problem of Inflation

Explore the history of modern macroeconomics and delve into the problem of inflation in the managed economy period from 1945 to 1975.

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The Managed Economy (1945-1975): The Problem of Inflation

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  1. History of Modern MacroeconomicsLecture 8. The Managed Economy (1945-1975) :The Problem of InflationKevin D. HooverDepartment of EconomicsDepartment of PhilosophyCenter for the History of Political EconomyDuke University Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  2. Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  3. Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  4. The Postwar International Monetary Order Bretton Woods Conference 1944 Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  5. The Gradual End of the Gold Standard • World War I: belligerent nations suspend gold standard • 1920s: most nations reinstate gold standard • Depression: many nations suspend or modify the gold standard • 1934: U.S. modifies the gold standard • nationalizes gold, ending domestic use of gold money • devalues the dollar from $20.67 to $35 per ounce of gold • World War II: Bretton Woods Agreement establishes gold exchange standard • 1971: U.S. ends convertibility of the dollar • 1973: U.S. briefly resumes convertibility at $42.22 per ounce • 1973: U.S. dollar becomes fully floating Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  6. The Wartime Controlled Economy Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  7. U.S. Wage and Price Controls • World War I: brief, limited wage and price controls • World War II: comprehensive wage and price controls and rationing of key commodities • Korean War: limited wage and price controls • 1971-73: Nixon institutes wage and price controls Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  8. 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] Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  9. Inflationary Gap from Samuelson’s, Economics, 3rd edition (1955) Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  10. 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] Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  11. Problem of Modeling Inflation • IS-LM and early econometric models designed to model level not inflation of prices (NB. Klein-Goldberger 1956 does have a wage-inflation equation) • 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) Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  12. 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: Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  13. The Phillips Curve • Empirical implementation of theoretical work on 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) • Goal to determine relative importance of cost-push and demand pull inflation in U.K. • “a wet weekend’s work.” (A.W.H. Phillips) Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  14. Phillips Implicit Dynamic Model • (w) = w-1 + U-1 –[w– f(U)]-1 +  short-run dynamics long-run relation (the Phillips curve) • w = log(wage rate) • w = rate of wage inflation • U = unemployment rate •  = error term Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  15. The Original Phillips Curve Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  16. Estimation of the Phillips Curve Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  17. Stability of the Phillips Curve Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  18. Inflation Dynamics – 1 • (w) = w-1 + U-1 –[w– f(U)]-1 +  short-run dynamics long-run relation (the Phillips curve) • w = log(wage rate) • w = rate of wage inflation • U = unemployment rate •  = error term Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  19. Inflation Dynamics – 2 w = –0.9w-1 – 0.3U-1 – 0.1[w+ (–0.9 – 9.638U-1.394)]-1 +  Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  20. Inflation Dynamics – 3 Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  21. 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) Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  22. The Phillips Curve Comes to America Paul Samuelson (1915-2009) Robert Solow (1926- ) Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  23. Relationship of Prices to Productivity – 1 • Cobb-Douglas production function: Y = AKL(1-) • mpL = dY/dL = (1–) AKL(-) = (1–)[AKL(1-)]/L = (1–)Y/L = (1–)s, • where s = Y/L = labor productivity (i.e., GDP per worker or GDP per worker hour) and  = capital share in in national income. • Profit maximization in perfect competition requires hiring labor until the real wage = the marginal product of labor or w/p = (1–)s • Similar results for non-Cobb-Douglas and for markup equations Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  24. Relationship of Prices to Productivity – 2 • The marginal product of labor: mpL =(1-)s • For profit maximization: w/p = (1-)s or, taking logarithms, log(w) – log(p) = log(1-) + log(s) and taking changes, Dlog(w) – Dlog(p) = Dlog(1-) + Dlog(s) • Rearranging: Dlog(w) = Dlog(p) + Dlog(s) or Dlog(p) = Dlog(w) – Dlog(s) since (1-) is a constant, Dlog(1-) = 0 Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  25. The U.S. Phillips Curve Wage Inflation/Unemployment Scatter Price Inflation Phillips Curve Samuelson and Solow, “Analytical Aspects of Anti-Inflation Policy,”AERPapers and Proceedings 1960 Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  26. Where the Price Phillips Curve Comes From • The unemployment wage inflation points are shifted by productivity growth of 2.5% per year so that • (5.5, 2.5)  (5.5, 0.0) • (3.0, 7.0)  (3.0, 4.5) • (8.0, 0.0)  (8.0, -2.5) Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  27. 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 Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  28. 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 Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  29. Friedman’s Presidential Address • “The Role of Monetary Policy,”AERPapers 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 Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  30. 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 Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  31. 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 Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  32. 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 • see work as natural development of Phillips not as critical Edmund Phelps (1933- ), Nobel Laureate 2006 Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  33. Challenge of Explaining the Short-run Phillips Curve – 1 • Expansionary monetary policy raises the inflation rate  • 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 • Phillips curve shifts over time as workers adjust expectations to higher rate of inflation and ↑U to NRU Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  34. 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, Samuelson & Solow, and Phelps: U (measure of AD) causes p • Friedman: p causes U (measure of AS) Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  35. 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 Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  36. 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 Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  37. Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  38. Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  39. 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 Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

  40. Thanks  The End Econ. 314S. History of Modern Macroeconomics Lecture 8, Fall 2017

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