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The Postwar International Monetary Order

History of Modern Macroeconomics Lecture 3.5. The Problem of Inflation (1950-1970) Kevin D. Hoover Department of Economics Department of Philosophy Center for the History of Political Economy Duke University. The Postwar International Monetary Order. Bretton Woods Conference 1944.

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The Postwar International Monetary Order

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  1. History of Modern MacroeconomicsLecture 3.5. The Problem of Inflation (1950-1970)Kevin D. HooverDepartment of EconomicsDepartment of PhilosophyCenter for the History of Political EconomyDuke University Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

  2. Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

  3. Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

  4. The Postwar International Monetary Order Bretton Woods Conference 1944 Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

  5. The Wartime Controlled Economy Economics 882 History of Modern Macroeconomics (Spring 2013, 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] Economics 882 History of Modern Macroeconomics (Spring 2013, 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] Economics 882 History of Modern Macroeconomics (Spring 2013, 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) Economics 882 History of Modern Macroeconomics (Spring 2013, 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) Economics 882 History of Modern Macroeconomics (Spring 2013, 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 Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

  11. The Original Phillips Curve Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

  12. Estimation of the Phillips Curve Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

  13. Stability of the Phillips Curve Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

  14. Dynamics of the Phillips Curve - 1 Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

  15. Dynamics of the Phillips Curve - 2 w = –0.9w-1 – 0.3U-1 – 0.1[w+ (–0.9 – 9.638U-1.394)]-1 +  Economics 882 History of Modern Macroeconomics (Spring 2013, 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) Economics 882 History of Modern Macroeconomics (Spring 2013, 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 Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

  18. The Phillips Curve Comes to America Paul Samuelson (1915-2009) Robert Solow (1926- ) Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

  19. 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 Economics 882 History of Modern Macroeconomics (Spring 2013, 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 Economics 882 History of Modern Macroeconomics (Spring 2013, 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 Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

  22. 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 Economics 882 History of Modern Macroeconomics (Spring 2013, 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 Economics 882 History of Modern Macroeconomics (Spring 2013, 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 Economics 882 History of Modern Macroeconomics (Spring 2013, 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 Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

  26. 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 Economics 882 History of Modern Macroeconomics (Spring 2013, 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) Economics 882 History of Modern Macroeconomics (Spring 2013, 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 Economics 882 History of Modern Macroeconomics (Spring 2013, 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 Economics 882 History of Modern Macroeconomics (Spring 2013, 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 Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

  31. Thanks  The End Economics 882 History of Modern Macroeconomics (Spring 2013, Module 2)

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