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4.3.2 The policy implications of the expectations-augmented Phillips curve

The scope for short-run output–employment gains The monetarist belief in

a long-run vertical Phillips curve implies that an increased rate of monetary

expansion can reduce unemployment below the natural rate only because the

resulting inflation is unexpected. As we have discussed, as soon as inflation is

fully anticipated it will be incorporated into wage bargains and unemployment

will return to the natural rate. The assumption underlying orthodox

monetarist analysis is that expected inflation adjusts to actual inflation only

gradually, in line with the so-called ‘adaptive’ or error-learning expectations

hypothesis. Interestingly, it seems that Friedman was profoundly influenced

by ‘Phillips’s adaptive inflationary expectations formula’ (Leeson, 1999). The

adaptive expectations equation implicit in Friedman’s analysis of the Phillips

curve, and used in Studies in the Quantity Theory of Money (1956), appears

to have been developed by Friedman in conjunction with Philip Cagan following

a discussion he had with Phillips which took place on a park bench

somewhere in London in May 1952 (Leeson, 1994b, 1997a). In fact Friedman

was so impressed with Phillips as an economist that he twice (in 1955

and 1960) tried to persuade him to move to the University of Chicago

(Hammond, 1996).

The main idea behind the adaptive expectations hypothesis is that economic

agents adapt their inflation expectations in the light of past inflation

rates and that they learn from their errors. Workers are assumed to adjust their

inflation expectations by a fraction of the last error made: that is, the difference

between the actual rate of inflation and the expected rate of inflation.

This can be expressed by the equation:

P˙ P˙ (P˙ P˙ ) t

e

t

e

t t

e −1 −1 (4.8)

The orthodox monetarist school 181

where is a constant fraction. By repeated back substitution expected inflation

can be shown to be a geometrically weighted average of past actual inflation

rates with greater importance attached to more recent experience of inflation:

P˙ P˙ ( )P˙ ( ) P˙ t

e

t t

n

1−−11−t−n (4.9)

In this ‘backward-looking’ model, expectations of inflation are based solely

on past actual inflation rates. The existence of a gap in time between an

increase in the actual rate of inflation and an increase in the expected rate

permits a temporary reduction in unemployment below the natural rate. Once

inflation is fully anticipated, the economy returns to its natural rate of unemployment

but with a higher equilibrium rate of wage and price inflation equal

to the rate of monetary growth. As we will discuss in Chapter 5, section 5.5.1,

if expectations are formed according to the rational expectations hypothesis

and economic agents have access to the same information as the authorities,

then the expected rate of inflation will rise immediately in response to an

increased rate of monetary expansion. In the case where there was no lag

between an increase in the actual and expected rate of inflation the authorities

would be powerless to influence output and employment even in the short

run.

The accelerationist hypothesis A second important policy implication of

the belief in a vertical long-run Phillips curve concerns the so-called

‘accelerationist’ hypothesis. This hypothesis implies that any attempt to maintain

unemployment permanently below the natural rate would result in

accelerating inflation and require the authorities to increase continuously the

rate of monetary expansion. Reference to Figure 4.4 reveals that, if unemployment

were held permanently at U1 (that is, below the natural rate UN), the

continued existence of excess demand in the labour market would lead to a

higher actual rate of inflation than expected. As the actual rate of inflation

increased, people would revise their inflation expectations upwards (that is,

shifting the short-run Phillips curve upwards), which would in turn lead to a

higher actual rate of inflation and so on, leading to hyperinflation. In other

words, in order to maintain unemployment below the natural rate, real wages

would have to be kept below their equilibrium level. For this to happen actual

prices would have to rise at a faster rate than money wages. In such a

situation employees would revise their expectations of inflation upwards and

press for higher money wage increases, which would in turn lead to a higher

actual rate of inflation. The end result would be accelerating inflation which

would necessitate continuous increases in the rate of monetary expansion to

validate the continuously rising rate of inflation. Conversely, if unemployment

is held permanently above the natural rate, accelerating deflation will

occur. Where unemployment is held permanently above the natural rate, the

continued existence of excess supply in the labour market will lead to a lower

actual rate of inflation than expected. In this situation people will revise their

inflation expectations downwards (that is, the short-run Phillips curve will

shift downwards), which will in turn lead to a lower actual rate of inflation

and so on. It follows from this analysis that the natural rate is the only level of

unemployment at which a constant rate of inflation may be maintained. In

other words, in long-run equilibrium with the economy at the natural rate of

unemployment, the rate of monetary expansion will determine the rate of

inflation (assuming a constant growth of output and velocity) in line with the

quantity theory of money approach to macroeconomic analysis.

Undoubtedly the influence of Friedman’s (1968a) paper was greatly enhanced

because he anticipated the acceleration of inflation that occurred during

the 1970s as a consequence of the repeated use of expansionary monetary

policy geared to an over-optimistic employment target. The failure of inflation

to slow down in both the US and UK economies in 1970–71, despite rising

unemployment and the subsequent simultaneous existence of high unemployment

and high inflation (so-called stagflation) in many countries, following the

first adverse OPEC oil price (supply) shock in 1973–4, destroyed the idea that

there might be a permanent long-run trade-off between inflation and unemployment.

Lucas (1981b) regards the Friedman–Phelps model and the verification

of its predictions as providing ‘as clear cut an experimental distinction as

macroeconomics is ever likely to see’. In the philosophy of science literature

Imre Lakatos (1978) makes the prediction of novel facts the sole criterion by

which theories should be judged, a view shared by Friedman (1953a). While

Blaug (1991b, 1992) has argued that the principal novel fact of the General

Theory was the prediction that the size of the instantaneous multiplier is greater

than one, he also argues that the prediction of novel facts emanating from

Friedman’s 1968 paper were enough to make Mark I monetarism a progressive

research programme during the 1960s and early 1970s. As Backhouse (1995)

notes, ‘the novel facts predicted by Phelps and Friedman were dramatically

corroborated by the events of the early 1970s’.

The output–employment costs of reducing inflation Friedman (1970c) has

suggested that ‘inflation is always and everywhere a monetary phenomenon

in the sense that it can be produced only by a more rapid increase in the

quantity of money than in output’. Given the orthodox monetarist belief that

inflation is essentially a monetary phenomenon propagated by excessive monetary

growth, monetarists argue that inflation can only be reduced by slowing

down the rate of growth of the money supply. Reducing the rate of monetary

expansion results in an increase in the level of unemployment. The policy

dilemma the authorities face is that, the more rapidly they seek to reduce

The orthodox monetarist school 183

Figure 4.6 The output–employment costs of reducing inflation

inflation through monetary contraction, the higher will be the costs in terms

of unemployment. Recognition of this fact has led some orthodox monetarists

(such as David Laidler) to advocate a gradual adjustment process whereby

the rate of monetary expansion is slowly brought down to its desired level in

order to minimize the output–employment costs of reducing inflation. The

costs of the alternative policy options of gradualism versus cold turkey are

illustrated in Figure 4.6.

In Figure 4.6 we assume the economy is initially operating at point A, the

intersection of the short-run Phillips curve (SRPC1) and the long-run vertical

Phillips curve (LRPC). The initial starting position is then both a short- and

long-run equilibrium situation where the economy is experiencing a constant

rate of wage and price inflation which is fully anticipated (that is, W˙ P˙ P˙ e

1)

and unemployment is at the natural rate (UN). Now suppose that this rate of

inflation is too high for the authorities’ liking and that they wish to reduce the

rate of inflation by lowering the rate of monetary expansion and move to

position D on the long-run vertical Phillips curve. Consider two alternative

policy options open to the authorities to move to their preferred position at

point D. One (cold turkey) option would be to reduce dramatically the rate of

monetary expansion and raise unemployment to UB, so that wage and price

inflation quickly fell to W˙3; that is, an initial movement along SRPC1 from

point A to B. The initial cost of this option would be a relatively large increase

in unemployment, from UN to UB. As the actual rate of inflation fell below the

expected rate, expectations of future rates of inflation would be revised in a

downward direction. The short-run Phillips curve would shift downwards and a

new short- and long-run equilibrium would eventually be achieved at point D,

the intersection of SRPC3 and LRPC where W˙ P˙ P˙ e

3with unemployment

at UN. Another (gradual) policy option open to the authorities would be to begin

with a much smaller reduction in the rate of monetary expansion and initially

increase unemployment to, say, UC so that wage and price inflation fell

to W˙2 , that is, an initial movement along SRPC1 from point A to C. Compared

to the cold turkey option, this gradual option would involve a much smaller

initial increase in unemployment, from UN to UC. As the actual rate of inflation

fell below the expected rate (but to a much lesser extent than in the first option),

expectations would be revised downwards. The short-run Phillips curve would

move downwards as the economy adjusted to a new lower rate of inflation. The

short-run Phillips curve (SRPC2) would be associated with an expected rate of

inflation of W˙2 . A further reduction in the rate of monetary expansion would

further reduce the rate of inflation until the inflation target of ˙W3 was achieved.

The transition to point D on the LRPC would, however, take a much longer

time span than under the first policy option. Such a policy entails living with

inflation for quite long periods of time and has led some economists to advocate

supplementary policy measures to accompany the gradual adjustment

process to a lower rate of inflation. Before we consider the potential scope for

such supplementary measures as indexation and prices and incomes policy, we

should stress the importance of the credibility of any anti-inflation strategy (this

issue is discussed more fully in Chapter 5, section 5.5.3). If the public believes

that the authorities are committed to contractionary monetary policies to reduce

inflation, economic agents will adjust their inflation expectations downwards

more quickly, thereby reducing the output–employment costs associated with

the adjustment process.

Some monetarists (for example Friedman, 1974) have suggested that some

form of indexation would be a useful supplementary policy measure to accompany

the gradual adjustment process to a lower rate of inflation. It is

claimed that indexation would reduce not only the cost of unanticipated

inflation incurred through arbitrary redistribution of income and wealth, but

also the output–employment costs that are associated with a reduction in the

rate of monetary expansion. With indexation, money wage increases would

automatically decline as inflation decreased, thereby removing the danger

that employers would be committed, under existing contracts, to excessive

money wage increases when inflation fell. In other words, with indexation

wage increases would be less rapid and unemployment would therefore rise

by a smaller amount. Further some economists (for example Tobin, 1977,

1981; Trevithick and Stevenson, 1977) have suggested that a prices and

incomes policy could have a role to play, as a temporary and supplementary

policy measure to monetary contraction, to assist the transition to a lower rate

of inflation by reducing inflationary expectations. In terms of Figure 4.6, to

The orthodox monetarist school 185

the extent that a prices and incomes policy succeeded in reducing inflationary

expectations, the short-run Phillips curves would shift downwards more

quickly. This in turn would enable adjustment to a lower rate of inflation to

be achieved both more quickly and at a lower cost in terms of the extent and

duration of unemployment that accompanies monetary contraction. However,

one of the problems of using prices and incomes policy is that, even if the

policy initially succeeds in reducing inflationary expectations, once the policy

begins to break down or is ended, inflationary expectations may be revised

upwards. As a result the short-run Phillips curve will shift upwards, thereby

offsetting the initial benefit of the policy in terms of lower unemployment

and wage inflation. For example, Henry and Ormerod (1978) concluded that:

Whilst some incomes policies have reduced the rate of wage inflation during the

period in which they operated, this reduction has only been temporary. Wage

increases in the period immediately following the ending of policies were higher

than they would otherwise have been, and these increases match losses incurred

during the operation of the incomes policy.

In summary, within the orthodox monetarist approach the output–employment

costs associated with monetary contraction depend upon three main

factors: first, whether the authorities pursue a rapid or gradual reduction in

the rate of monetary expansion; second, the extent of institutional adaptations

– for example, whether or not wage contracts are indexed; and third, the

speed with which economic agents adjust their inflationary expectations downwards.

The monetarist view that inflation can only be reduced by slowing down

the rate of growth of the money supply had an important bearing on the

course of macroeconomic policy pursued both in the USA (see Brimmer,

1983) and in the UK during the early 1980s. For example, in the UK the

Conservative government elected into office in 1979 sought, as part of its

medium-term financial strategy, to reduce progressively the rate of monetary

growth (with pre-announced target ranges for four years ahead) in order to

achieve its overriding economic policy objective of permanently reducing the

rate of inflation. Furthermore, the orthodox monetarist contention that inflation

cannot be reduced without output–employment costs appears to have

been borne out by the recessions experienced in the US and UK economies in

1981–2 and 1980–81, respectively (see Chapter 5, section 5.5.2). For wellwritten

and highly accessible accounts of the background to, and execution

and effects of what the media dubbed ‘Thatcher’s monetarist experiment’, the

interested reader is referred to Keegan (1984) and Smith (1987).

The role and conduct of monetary policy The belief in a long-run vertical

Phillips curve and that aggregate-demand management policies can only

affect the level of output and employment in the short run has important

implications for the role and conduct of monetary policy. Before discussing

the rationale for Friedman’s policy prescription for a fixed monetary growth

rule, it is important to stress that, even if the long-run Phillips curve is

vertical, arguments justifying discretionary monetary intervention to stabilize

the economy in the short run can be made on the grounds of either the

potential to identify and respond to economic disturbances or the length of

time required for the economy to return to the natural rate following a

disturbance. Friedman’s policy prescription for a fixed rate of monetary growth

(combined with a floating exchange rate), in line with the trend/long-run

growth rate of the economy, is based on a number of arguments. These

arguments include the beliefs that: (i) if the authorities expand the money

supply at a steady rate over time the economy will tend to settle down at the

natural rate of unemployment with a steady rate of inflation, that is, at a point

along the long-run vertical Phillips curve; (ii) the adoption of a monetary rule

would remove the greatest source of instability in the economy; that is, unless

disturbed by erratic monetary growth, advanced capitalist economies are

inherently stable around the natural rate of unemployment; (iii) in the present

state of economic knowledge, discretionary monetary policy could turn out to

be destabilizing and make matters worse rather than better, owing to the long

and variable lags associated with monetary policy; and (iv) because of ignorance

of the natural rate itself (which may change over time), the government

should not aim at a target unemployment rate for fear of the consequences

noted earlier, most notably accelerating inflation.

We finally consider the implication of the belief in a natural rate of unemployment

for employment policy.

The natural rate of unemployment and supply-side policies As we have

discussed earlier, the natural rate of unemployment is associated with equilibrium

in the labour market and hence in the structure of real wage rates.

Friedman (1968a) has defined the natural rate as:

the level that would be ground out by the Walrasian system of general equilibrium

equations provided there is embedded 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.

What this approach implies is that, if governments wish to reduce the natural

rate of unemployment in order to achieve higher output and employment

levels, they should pursue supply-management policies that are designed to

improve the structure and functioning of the labour market and industry,

rather than demand-management policies. Examples of the wide range of

The orthodox monetarist school 187

(often highly controversial) supply-side policies which were pursued over the

1980s both in the UK (see for example Vane, 1992) and elsewhere include

measures designed to increase: (i) the incentive to work, for example through

reductions in marginal income tax rates and reductions in unemployment and

social security benefits; (ii) the flexibility of wages and working practices, for

example by curtailing trade union power; (iii) the occupational and geographical

mobility of labour, for example in the former case through greater

provision of government retraining schemes; and (iv) the efficiency of markets

for goods and services, for example by privatization.

Following the Friedman–Phelps papers the concept of the natural rate of

unemployment has remained controversial (see Tobin, 1972a, 1995; Cross,

1995). It has also been defined in a large variety of ways. As Rogerson (1997)

shows, the natural rate has been equated with ‘long run = frictional = average =

equilibrium = normal = full employment = steady state = lowest sustainable =

efficient = Hodrick–Prescott trend = natural’. Such definitional problems have

led sceptics such as Solow (1998) to describe the ‘doctrine’ of the natural rate

to be ‘as soft as a grape’. When discussing the relationship between unemployment

and inflation many economists prefer to use the ‘NAIRU’ concept

(non-accelerating inflation rate of unemployment), a term first introduced by

Modigliani and Papademos (1975) as ‘NIRU’ (non-inflationary rate of unemployment).

While the majority of economists would probably admit that it is

‘hard to think about macroeconomic policy without the concept of NAIRU’

(Stiglitz, 1997), others remain unconvinced that the natural rate concept is

helpful (J. Galbraith, 1997; Arestis and Sawyer, 1998; Akerlof, 2002).