Is current monetary policy consistent with maintaining a low rate of inflation? Would the establishment of price stability as the Fed’s sole objective hinder long-run growth prospects for the U.S. economy?
- Inflation and unemployment in the short run
- Does monetary policy predictable affect unemployment
- Theory, evidence, and policy
- The future
Is current monetary policy consistent with maintaining a low rate of inflation? Would the establishment of price stability as the Fed’s sole objective hinder long-run growth prospects for the U.S. economy? The answers to these questions are critical for the design and implementation of monetary policy, and one means of assessing the progress economists have made in recent years in addressing them is to examine the views of two Nobel laureates in economics; the Nobel Lectures of Milton Friedman (1977) and Robert Lucas (1996), separated by almost 20 years, provide benchmarks for reviewing developments in the way economists think about inflation and unemployment.
Friedman and Lucas are two of the giants of monetary economics. Friedman, the winner of the Nobel Prize in Economics in 1976, is most widely known for his emphasis on the role of monetary policy as a force in shaping the course of inflation and business cycles; outside the field of economics, he also is known for his advocacy of free markets. Lucas, who will be honored at the American Economic Association’s annual meetings in January, was probably unfamiliar to most non-economists when he was awarded the Nobel Prize in 1995. Like Friedman, he too has made fundamental contributions to the study of money, inflation, and business cycles.
When Friedman gave his lecture in 1976, the long-run relationship between inflation and unemployment was still under debate. During the 1960s, most economists believed that a lower average unemployment rate could be sustained if one were just willing to accept a permanently higher (but stable) rate of inflation. Friedman used his Nobel lecture to make two arguments about this inflation-unemployment tradeoff. First, he reviewed the reasons the short-run tradeoff would dissolve in the long run. Expanding nominal demand to lower unemployment would lead to increases in money wages as firms attempt to attract additional workers. Firms would be willing to pay higher money wages if they expected prices for output to be higher in the future due to the expansion. Friedman assumed, however, that workers would initially perceive the rise in money wages to be a rise in real wages. They would do so because their “perception of prices in general” adjusts slowly, so nominal wages would be perceived to be rising faster than prices. In response, the supply of labor would increase, and employment and output would expand. Eventually, workers would recognize that the general level of prices had risen and that their real wages had not actually increased, leading to adjustments that would return the economy to its natural rate of unemployment.
Friedman’s second argument was that the Phillips Curve slope might actually be positive–higher inflation would be associated with higher average unemployment. In the 1970s, many economies were experiencing rising inflation and unemployment simultaneously. Friedman attempted to provide a tentative hypothesis for this phenomenon. In his view, higher inflation tends to be associated with more inflation volatility and greater inflation uncertainty. This uncertainty reduces economic efficiency as contracting arrangements must adjust, imperfections in indexation systems become more prominent, and price movements provide confused signals about the types of relative price changes that indicate the need for resources to shift.
The positive correlation between inflation and unemployment that Friedman noted was subsequently replaced by a negative correlation as the early 1980s saw disinflations accompanied by recessions. Today, most economists would view inflation and unemployment movements as reflecting both aggregate supply and aggregate demand disturbances as well as the dynamic adjustments the economy follows in response to these disturbances. When demand disturbances dominate, inflation and unemployment will tend to be negatively correlated initially as, for example, an expansion lowers unemployment and raises inflation. As the economy adjusts, prices continue to increase as unemployment begins to rise again and return to its natural rate. When supply disturbances dominate (as in the 1970s), inflation and unemployment will tend to move initially in the same direction.
Almost all economists have followed Friedman in accepting that there is no long-run tradeoff that would allow permanently lower unemployment to be traded for higher inflation. And a part of the reason for this acceptance is due to the contributions of Lucas.
In his Nobel lecture, Lucas notes that while clear evidence exists that average inflation rates and average money growth rates are tightly linked: “The observation that money changes induce output changes in the same direction receives confirmation in some data sets but is hard to see in others. Large-scale reductions in money growth can be associated with large-scale depressions or, if carried out in the form of a credible reform, with no depression at all” (p. 668). Lucas draws this conclusion largely from work on episodes of hyperinflations (Sargent 1986) in which major institutional reforms have been associated with large changes in inflation; when major reforms are not involved, the evidence shows a more consistent effect of monetary policy expansions and contractions on real activity.
While Friedman also stressed that the real effects of changes in monetary policy would depend on whether they were anticipated or not, Lucas demonstrated the striking implications of assuming that individuals form their expectations rationally. Lucas abandoned Friedman’s notion of a gradual adjustment of expectations based on past developments and instead stressed the forward-looking nature of expectations. Expectations of future monetary easing or tightening will affect the economy now. And this means that the real effects of, say, an increase in money growth could, in principle, be expansionary or contractionary, depending on the public’s expectations.
One consequence of this insight has been a new recognition of the importance of credibility in policy; that is, a credible policy–one that is explicit and for which the central bank is held responsible–can influence the way people form their expectations. Thus, the effects of policy actions by a bank with credibility may be quite different from those of a central bank that lacks credibility. Even though the empirical evidence for credibility effects is weak, the emphasis on credibility has been one factor motivating central banks to design policy frameworks that embody credible commitments to low inflation.
Some economists have begun to question the natural rate result that Lucas’s work helped to promote. Akerlof, Dickins, and Perry (1996), for example, argue that even credible low-inflation policies are likely to carry a cost in terms of permanently higher unemployment and that a stable Phillips Curve tradeoff exists at low rates of inflation. They argue that employee resistance to money wage cuts will limit the ability of real wages to adjust when the price level is stable. But the contributions of Friedman and Lucas have clearly shifted the debate since the early 1970s. Now it is proponents of a tradeoff who represent the minority view.
Both Friedman and Lucas motivated their discussions of the relationship between monetary policy and unemployment by presenting empirical evidence. This similarity reveals an important characteristic of macroeconomics — theory is tightly linked with empirical evidence. Yet, while sharing a common approach, the two Nobel laureates stress different aspects of the connection between theory, evidence, and policy.
For example, Friedman and Lucas differ in their views on what is responsible for advances in our understanding of money and output. Friedman stresses the role of empirical evidence. He argues that the growing evidence that the 1960s vintage Phillips Curve was unstable was instrumental in forcing the profession to adjust its thinking. As Friedman puts it, “the drastic change that has occurred in accepted professional views was produced primarily by the scientific response to experience that contradicted a tentatively accepted hypothesis — precisely the classical process for the revision of a scientific hypothesis” (p. 453) .
In contrast, Lucas stresses the role played by mathematical tools in leading to advances in economics. As he notes, the effects of money on the economy involve the dynamic response of economic agents to changes in prices, interest rates, and income. Much of modern macroeconomics consists of working out the implications of these dynamic responses, and the development of theoretical models of these responses would be futile “without any of the equipment of modern mathematical economics” (p. 669). Economists needed the appropriate formal tools before progress could be made in understanding the dynamic nature of the individual decisions that affect the economy’s behavior over time.
Lucas also emphasizes the role of theory in influencing practical macroeconomics: “All one can be sure of is that progress will result from the continued effort to formulate explicit theories that fit the facts, and the best and most practical macroeconomics will make use of developments in basic economic theory” (p. 680). In contrast, Friedman’s stress is on the role of evidence in the battle among competing theories: “… brute experience proved far more potent than the strongest of political or ideological preferences” (p. 470).
The insights of Friedman and Lucas continue to guide developments in macroeconomics. Their work on the links between inflation and unemployment has influenced the course of economic theory and the most practical of policy discussions. For example, Lucas’s development of a theory of expectations served to emphasize the role of credibility in the conduct of policy, an emphasis that continues to have a major impact on discussions dealing with proposals for inflation targeting and for legislative mandates to require central banks to treat price stability as their sole objective.
Both Friedman and Lucas speculated on promising areas for research. Friedman emphasized the need to incorporate more explicit models of political behavior in order to understand the determinants of policy. This was quite natural; once economists gained a clear understanding of the effects of monetary policy on the economy, understanding why nations had undergone differing inflation experiences became an issue of understanding how different political structures had generated differing policy outcomes.
Friedman was amazingly prescient; the very article following his Nobel Lecture in the Journal of Political Economy was a paper by Kydland and Prescott (1977) that lay the groundwork for the huge literature on time inconsistency of discretionary policy. By providing a framework for analyzing the way in which the economic structure can interact with the incentives faced by policymakers, Kydland and Prescott provided the foundations of a political theory of inflation consistent with the natural rate models of Friedman and Lucas and set the language of debate for most current discussions of central banking reform.
Lucas noted that the specific models developed during the first generation of the rational expectations revolution have not proven successful as theories of the business cycle and that more work incorporating monetary phenomena into general equilibrium real business cycle models was likely to occupy the research agendas of monetary economists in the near future. However, he also expressed the view that speculating on future directions was difficult: “… who can say how the macroeconomic theory of the future will develop, any more than anyone in 1960 could have foreseen the developments I have described in this lecture?” (p. 680).
Carl E. Walsh
Visiting Scholar, FRBSF
Professor of Economics, U.C. Santa Cruz
Akerlof, George, William Dickens, and George Perry. 1996. “The Macroeconomics of Low Inflation.” Brookings Papers on Economic Activity 1, pp. 1-59.
Friedman, Milton, 1977. “Nobel Lecture: Inflation and Unemployment.” Journal of Political Economy 85, pp. 451-472.
Kydland, F.E., and E.C. Prescott. 1977. “Rules Rather than Discretion: The Time Inconsistency of Optimal Plans.” Journal of Political Economy 85, pp. 473-491.
Lucas, Robert E., Jr. 1996. “Nobel Lecture: Monetary Neutrality.” Journal of Political Economy 104, pp. 661-682.
Sargent, Thomas J. 1986. “The Ends of Four Big Inflations.” In his Rational Expectations and Inflation, New York: Harper and Row.
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