Archive for February, 2008

A Response to Stockman’s “Real Business Cycle Theory: A Guide, an Evaluation, and New Directions”

Thursday, February 28th, 2008

Alan Stockman comes right out and states the purpose of real business cycle (RBC) models–that is, these models are used to “explain aggregate fluctuations in business cycles without reference to monetary policy.”  In fact, he goes on to make four assertions as to why the real business cycle model is important.  From evidence gathered, monetary policy does not affect the real output as much as economists once believed.  Second, even if it does affect the real output of the economy, it isn’t the driving force behind the business cycle, supply shocks and non-monetary occurrences usually influence the aggregate fluctuations to a greater degree than monetary policy, and lastly, real business cycle models can be used to determine how disturbances affect different sectors of the economy.  These real business cycle models incorporate the following: GDP, consumption, fixed assets (i.e. investment, nonresidential, structures, equipment), average nonfarm employment, and capital stocks.  Stockman notes that others have used variations of the real business cycle model to include cross-sector analyses to track output and production across the aggregate economy in order to trace the disturbances from one sector to another.

Stockman starts the discussion on real business cycle (RBC) models with two assumptions–people maximize their utility with different combinations of leisure and consumption and there’s a technology coefficient that allows for the transformation of capital and labor into output that can be either consumed by households or reinvested back into capital stocks for period t+1.  Stockman traces some early, prototype models that had their roots with RBCs.  One of the first was Kydland and Prescott, who used backwards induction to come up with an abstract model that looked at utilization of capital, lagged effects of leisure on utility, and imperfect information about productivity.  Hansen furthered the Kydland-Prescott 1982 model by adding a “lottery on employment,” in which people are assumed to either work full time or not at all, without looking at part-time work.  This lottery of employment assumes that people that choose to work and those who choose not to work are randomly selected.  The Greenwood et al. model looks at current and future investment.  It is noted that the model shows increases in consumption, labor supply, output, and investment are due to current economic conditions.  The model discusses technology shocks as one factor, but that would only increase future output resulting from increases in future capital.  Current output, however, is affected by current economic conditions.  Kydland-Prescott’s 1988 model incorporates that the cost of a greater utilization of capital is a greater utilization of labor.  This variable work week (a longer work week) predicts the variability in the U.S. inventories.  Parkin (1988) tried to calculate the parameters in the Cobb-Douglas production function using labor data from the GDP.  He determined that these parameters varied over time and as a result, was able to calculate the technology shock.  Because his model showed the share of leisure s(preference shock) relatively stable over time, this implied that preference shocks can be viewed as unimportant to RBC models.  The last model mentioned is that of Christiano and Eichenbaum (1988), which looked at government shocks as affecting shifts in the labor supply curve.  Coupled with technology shifts, these two movements could induce changes to the real wage.

Stockman starts his discussion on RBC models by listing parameters often included in these models.  They include the fraction of total time spent working and the time spent in leisure, the psychological factor, the rate of capital depreciation, the marginal rate of substitution in consumption, the marginal rate of substitution in leisure, labor as a percentage of GDP, and the variance of productivity shocks.  However, the one common criticism is how to use the RBC models to explain periods in which real output falls using the logic that negative technology shocks exist.  (This is most commonly observed in smaller sectors of the economy.)  What Robert Hall (1988) deems the most important is the ability to differentiate between temporary reductions (aggregate output) from permanent reductions (measured output).  However, I don’t understand the difference bewteen the above logic dealing with negative technological shocks and the difference between measured output and total output (page 32).

An interesting note when discussing the criticisms, Stockman observes that econometric tests may reject the RBC model.  This is because the models may be wrong due to large influences in measurement errors.  Even if they prove to be wrong, RBC models have been shown to give better advice for policymakers than other incorrect theories.  Another criticism is that involuntary unemployment isn’t explained by RBC models.  The example looks at two individuals–both of whom have the same tastes and preferences and characteristics, but the only difference is that one is employed and one is unemployed.  However, the model will not differentiate between the two; the only explanation is that unemployment is the result of a random fluctuation in productivity within the economy.  Going back to the technology criticism, Stockman proposes the question that technology shocks may be more influential to a group of industries rather than the nation as a whole.  Thus, this brings into question that though technology shocks are important, nation-specific disturbances play at least as large of a role in output fluctuations as these technology shocks.

To see if the RBC model explains the random fluctuations of the international economies, there are two “tests.”  One is to see if the goodness of fit improves with the addition of more variables, but this requires the addition of more equations and more parameters.  The other is to test the RBC model with the same criteria and parameters to a different set of macroeconomic facts.  These RBC models should work fairly well because exchange rates look at the relationship between currencies (relative and nominal) due to “real shocks,” which are what RBCs are trying to model and explain.  However, the one obstacle that will be encountered is that various economies have different parameters and disturbances.

The ultimate question is whether these real business cycle models should be used for optimal policy decisions.  If the assumptions of RBC models are true, then monetary policy will have no effects on the real output of the economy.  To achieve optimal policy responses, as was suggested in our reading of Kydland and Prescott, there can be no fiscal and monetary interventions because policies are made based on expectations and conditions in time t.  The policy is implemented assuming the status quo, but once the policy is implemented, in time t+1, t+2, … , t+n, expectations will change and the policy will not achieve the optimal response.  Another thing to consider, which goes along with the Kydland-Prescott model is that the responses of the economy (to changes in regimes/administrations) bring about these suboptimal conditions because of market failures.  Stockman ends the discussion by stating that fluctuations in the economy are most likely optimal resopnses to uncertainty, rather than the failure of markets to clear, which was the general thinking of Keynesian economists and monetarists.  Essentially, the RBC should be concerned with long-run rates of technological change and low inflation instead of large fluctuations in GDP because those fluctuations are random and shouldn’t be “massaged” by either monetary or fiscal intervention.

Source: Stockman, Alan C.  1988.  Real business cycle: A guide, an evaluation, and new directions.  Economic Review 24 no. 4 (Quarter 4): 24-43.

A Response to Hoover’s The New Classical Macroeconomics

Tuesday, February 19th, 2008

In Kevin Hoover’s introduction, he discusses as to why Keynesian economics began to fade away by the 1970s.  The “Keynesian dominance of macroeconomics” ended because of the “absence of microfoundations for macroeconomics.”  Hoover cites two prime examples where microfoundations are incorporated into aggregate economic relationships–the life-cycle model and permanent-income hypothesis.  Don Patinkin sought to prove these two theories using the value theory of money and rational expectations and decided that Keynesian economics was the “economics of disequilibrium” because when labor markets are in equilibrium, there is no involuntary unemployment.  In continuing reading, I couldn’t quite understand the microfoundations that Keynes had left out of his model nor why his models dealing with the labor market were considered in disequilibrium.  Hoover continues the macroeconomic story by mentioning the fact that both Milton Friedman and Edmund Phelps recognized that there is no long-run trade off between unemployment and inflation.  Only in the short run, however, can the two be traded off so as long as people mistake absolute prices (nominal) for higher relative prices (real).  Thus, it is important to note that both Friedman and Phelps recognized that expectations plays a large role in determining how high inflation can be to lower the unemployment rate because once people don’t confuse the real and nominal prices, the two rates will both increase and there will no longer be a trade off.  It was at this point that John Muth’s idea of rational expectations started to confound policymakers and thus macroeconomic policy was proven to be ineffective during the 1970s when the country faced both high inflation rates and high unemployment rates.  This idea of stagflation and incorporation of rational expectations is what Kevin Hoover cites as the second factor that led to the downfall of Keynesian economics.

The birth of new classical macroeconomics became prominent in the 1980s when economists used rational expectations in their models because they believed that “macroeconomic models are legitimate only if they possess market-clearing microfoundations grounded in individual rationality.”  The first question that needs to be addressed is the difference between classicals and Keynesians.  In class, we did look at this comparison, but I will reiterate it in the blog once more.  Classicals view the aggregate supply curve as vertical.  As the price rises, the real wage will fall and employers will want to hire more labor, but workers won’t work for lower real wages and therefore, the labor supply market is no longer in equilibrium (demand > supply) and the only way to return to equilibrium is to raise nominal wages by as much as the increase in the price level.  At this point, the old real wage is reached again and full employment is at the same level as before the rise in prices.  Therefore, inflation doesn’t affect GDP potential.  According to Hoover, the Keynesians viewed the aggregate supply curve as a J-curve because Keynes couldn’t explain it, but still made the assumption that there was some involuntary unemployment in the labor market.  As a result, employers could hire those individuals at lower real wages, which would put the employment level at a level greater than what it previously was, and consequently, push GDP potential to the right.  However, even Keynes recognized that the real wage couldn’t drop below it’s market-clearing level (where supply = demand) because workers wouldn’t accept those low real wages.  In this section of Chapter 1, Hoover makes one last comparison between classicals and Keynesians in that he said that classicals believed that the monetary side (i.e. changes in the money supply) only affected nominal output whereas Keynesians believed that the monetary side could have real effects on GDP.  Afterwards, he comments that the neoclassical synthesis between classicals and Keynesians was in describing the vertical section of Keynes’ J-curve because at that point, the economy is in equilibrium.  (It is here where Hoover makes it known that their biggest accomplishment was in developing the Phillips curve.)

 The quantity theory of money was “kept alive” by the monetarists who also believed that long-run markets cleared, which is modeled by a vertical aggregate supply curve.  The biggest distinction for defining a monetarist is someone who ascribes to the notion that inflation is a monetary phenomenon–that is, if the money supply is increased by x percent, then the price level will increase by x percent and be returned to the GDP potential.  (In the short run, however, Hoover notes that an increase in aggregate demand will increase actual GDP, but at a higher price.  When people’s expectations come in to focus with the higher prices, the aggregate supply curve will shift up and GDP will return to potential, but at even higher prices than before.

As new classical economics came into being, it was first considered “radical monetarism” because it built in expectations into the Phillips curve model.  Essentially, the model of aggregate demand-aggregate supply (long- and short-run) looks identical except for the fact that the aggregate supply curves have been replaced by “virtual aggregate supply” curves that reflect “money illusion” (i.e. real prices rather than absolute prices should matter to them) that is, once people’s expectations account for the random errors, they will move off of the curve.  Thus, if the shift in aggregate demand is expected, the price level will increase but the GDP potential will remain unchanged.  However, if the change is unanticipated, then GDP actual will move past GDP potential at a higher price, but when people realize the higher prices, GDP actual will move back to GDP potential at the cost of even higher prices.  Essentially, new classicals view the aggregate curves as nothing more than “crude devices that do not reveal the underlying behavior of optimizing individuals.”  According to the classicals, these graphical relationships shouldn’t be the basis for any economic analysis.

Hoover lists three tenets for new classicals–(1) savings, consumption, or investment are based on real, not nominal factors; (2) agents seek to maximize but are constrained by the limits of their information; and (3) agents make decisions with rational expectations.  The author also stresses the role of rational expectations.  As in class, the book, too, discusses two forms of rational expectations.  Either people do the best they can with the information they have (weak form of rational expectations) or people construct a model of the world and use that model to form their expectations (strong version of rational expectations).  Hoover extends the idea of rational expectations to Milton Friedman’s natural rate of unemployment hypothesis (1968).  Here, Hoover validates Friedman’s hypothesis by stating that there will be short-run deviations from the natural rate only because people mistake changes in their nominal wages for changes in their real wages.

Lucas and Rapping (1969) modified Friedman’s natural rate hypothesis and can probably be the first paper to deserve the title of “new classical.”  The two suggest that Friedman assumed labor supply to be elastic–that is, as wage rates increased, the labor supply would increase indefinitely.  However, this is not fully true because labor supply is dependent on population constraints and demographic changes and as a result, the long-run labor supply is inelastic with respect to the real wage.  Friedman generated an unemployment model based on people’s adaptive expectations of wages in time period t-1 and t, but Lucas and Rapping didn’t think adaptive expectations explained the fluctuations in unemployment.  The two felt that people’s expectations always lagged behind the real wage in time t because of unanticipated increases in the level of inflation, and consequently, the laborers would consistently think that their real wage was higher than normal, but eventually there would be decreases back to the original levels of employment.  This lagged expectation is why they didn’t think that expectations fit into the model of the natural rate.  Nevertheless, the one point that Lucas stresses is that agents act rationally, but will still make mistakes (random) that can be large or small.  The key to rational expectations, though, is to develop a rational expectation model that minimizes those mistakes so he can discern what was due to real price changes versus inflationary pressures.

Source: Hoover, Kevin D.  1988.  The new classical macroeconomics.  Cambridge, Massachusetts: Basil Blackwell.

A Response to Bosworth’s Tax Incentives and Economic Growth

Friday, February 15th, 2008

Bosworth notes that supply-side economics is used in two different instances.  One is in the broad sense where the “volume and quality of the capital and labor inputs” determine the aggregate supply and the other is a narrower focus that emphasizes that tax reductions “increase the supply of saving, investment, and labor.”  Supply-side economics received a lot of attention in the late 1960s and 1970s due to high inflation rates.  The classicals didn’t view demand management as a problem and thought that prices would adjust as a result of disequilibriums in the market, especially in the labor market, and as a result of the quick changes in prices, the market would clear.  Keynesian economists came along next and observed that a decrease in demand in one market would lead to unemployment.  This unemployment would cause reductions in other markets because their incomes would fall and thus, they would consume less.  Therefore, where the Keynesians and classicals differed was in the speed of prices adjusting to changes in the market.  Whereas the classicals thought that price levels adjusted quickly, Keynesians observed sticky prices, and consequently, it was those sticky prices that created a gap between supply and demand.  Up until the 1960s, it was a general consensus that government policy did little in the way of changing the short-run path of potential GDP.  (For individual markets, the potential GDP can be changed because resources can be shifted from one market where the returns aren’t maximized to the market where the resources are used to their fullest potential.)  However, the overall economy is different in that supply is limited by the growth rate in both labor and capital.  Thus, since demand management was seemed as ineffective in combating high rates of inflation and unemployment in the late 1960s and 1970s, supply-side economics became the focus.  The new economic thought, however, had its own problems–political in nature–because supply-side economics deals with changes in taxes.

At first, though, people weren’t too receptive to the idea of supply-side economics because they felt that the government went too far in redistributing taxes and thus eroding people’s incentive to work.  Bosworth does note here that neo-Keynesians cannot be blamed for all these problems centered around inflation because demand management had greatly increased during the Vietnam War and the disruption of oil from the Middle East in the early 1970s created domestic economic problems.  The neo-Keynesians did, however, try to curb the recession in the 1970s by inducing mild recessions, but at the expense of higher unemployment.  Therefore, due to the fact that the public was dissatisfied with the roller coaster ride of the inflation-unemployment trade off, new theories to guide macroeconomic policies emerged.

It was an observed trend of the 1970s that the overall economy and worker productivity both slowed down (and between 1977-1982, worker productivity failed to grow at all).  At first this was perceived as temporary, but it soon became realized that this may be the new status of the economy–since people were used to an average of 3 percent growth since the end of WWII.  The frustrations came when workers perceived that their real wages were falling due to the high inflation rates.  More importantly, the notice of the lack of productivity growth in the economy made people realize that there would be few extra resources to put towards other social programs, and consequently, this laid the groundwork for increased social conflict among the various races and ethnic groups in America.

Out of the foreseeable social conflict came the notion that greater emphasis needed to be placed with the supply side of the economy.  At the current time, there was little or no consensus as to the “sensitivity of wages and prices to changes in demand and the responsiveness of supply to changes in wages, prices, taxes, and government benefits.”  Economists agree that “fixprice” markets represent the short run where prices are rigid and don’t respond to changes in the money supply due to lagged effects whereas “flexprice” markets represent the long run where prices are positively related to changes in the money supply.  (The only grey area, however, is the definition of the short- and long-run.)  In answer to the second question, people haven’t been able to quantify the magnitudes of the effects of changes in supply due to changes in the rates of return or relative prices when deciding on saving and investment choices.

Supply-side economists concur with the American neoclassicalists that supply (i.e. capital and labor) is largely effected by changes in the price level, which can be viewed as tax reductions because then people have more take-home income.  What supply-side economists feel is that more money in the economy via tax reductions will create an increase to entrepreneurial innovation, and thus, a greater work effort.  (This differs from earlier thoughts that concluded that tax reductions would ultimately reduce work effort because someone would wonder why they would have to work as hard as they did before if they end up with the same after-tax income as a result of the new tax break.)  Supply-side economists criticized Keynesian economics on the grounds that Keynesians believed in the “involuntary unemployment” due to mismatches the aggregate supply and demand.  However, the supply-side economists observed that the only reason to “involuntary unemployment” was as a result of information lags and errors in forecasting models developed by firms.  Some even went as far to state that fiscal policy has little or no effect on aggregate demand if the public wasn’t affected at all by interest rates.  Thus, these individuals favored monetary policy to affect the rates of change of GDP.

All in all, the supply-side view credits the increase in both capital and labor to the 1964 tax reduction because without this increase in after-tax incomes, there wouldn’t have been increased spending, which would never have led to increases in “production, employment, investment, and income.”  The rise in after-tax incomes had a significant impact on worker productivity.  With a lower tax bracket, employees offered to work more hours in return for a higher after-tax wage.  Where the criticism comes into play with the supply-side view is the magnitude and absolute effects that these supply changes (i.e. capital and labor) really had on productivity and output.  Were people responding strictly to economic incentives (i.e. lower tax rates) or did the improvements in technology have a larger impact?  Of course, there are numerous factors at play that cannot be controlled outside of a laboratory setting.  On the one hand, the substitution effect would say that people would work more hours at the expense of leisure due to higher after-tax incomes, but others would cite the income effect and claim that people would want more leisure, and therefore, give up work hours.  The impact on savings is another area of question.  Some would argue that the increased after-tax income would encourage people to save more, but there are those who feel that people consume based on present and future streams of income, and as a result, would consume more at the present time, which indicates that the net change in savings is ambiguous.  The effects on capital investments are also uncertain because an increased after-tax income would make capital cheaper relative to labor, but “cheaper” capital wouldn’t alter the production process that measurable because firms make decisions based on combinations of both capital and labor.

Source: Bosworth, Barry P.  1984.  Tax Incentives and Economic Growth.  Washington DC: The Brookings Institution.

A Response to Kantor’s “Rational Expectations and Economic Thought”

Thursday, February 7th, 2008

According to Kantor, Keynesian economics began to be undermined following 1945 when the country experienced high levels of employment.  Keynes’ model assumed the rigidity (sticky) of real wages, but Don Patinkin claimed that “the involuntary unemployment and flexible money wages precludes the existence of equilibrium.”  Essentially, he “freed” the once static logic that decreases in employment led to increases in the real wage rate.  Instead, he noted that unemployment was a result of economic dynamics and that the real balance effect was due to flexibility, rather than rigidity, of the wage rate in equilibrium.  (Not knowing what the real balance effect was, I took it upon myself to look it up and this is what I found.  The real balance effect can be defined as an increase in somebody’s real wealth and thus an increase overall consumption due to a decrease in the aggregate price level.)

There is a large contrast between Keynesian economics and monetarists that incorporate expectations into their models.  Keynesians believed that in order to secure full employment, the only thing required would be to adjust real wages and increase the overall price level.  However, this would be proven later not to work because people, in fact, do pay attention to inflation.  Thus, the above-statement would result in only an increase in nominal wages, not real wages.  In the late 1960s, along came Milton Friedman and Edmund Phelps who both said that it is impossible to “fool all the workers all the time.”  That is, laborers are aware of the trade off between inflation and real wages and consequently, the inverse relationship between unemployment and inflation.  With the realization that expectations weren’t factored into the model, economists were soon to escape the “static general equilibrium.”

Early on, expectations, as modeled by Phillip Cagan, were assumed to be weighted averages of previous rates of changes in the aggregate price level.  While this seemed like a feasible model, there was still the understanding that the Phillips curve held true and policymakers could trade inflation for employment levels.  Eventually, the theory failed in the 1970s when the country experienced stagflation–that is, high levels of both unemployment and inflation.  (At this point, people began to abandon the Phillips curve for a short-run Phillips curve that said the relationship held true, but only in the short run.)

Soon, rational expectations came to the forefront of macroeconomic thought.  The inventor…John F. Muth.  He developed these expectations to “make dynamic economic models complete.”  Muth realized that there was great profit to be made by forecasting future expectations, especially if the predictions of economic theory were much better than the predictions developed by the firms.  Because rational expectations are built in to the current models, they can be assumed to be profit-maximizing since that is the goal of every firm.  However, if the past trends prove to be imperfect in forecasting current and future trends, then the practice of rational expectations will be inaccurate.  To guarantee the validity of the model developed, Muth had to assume that random disturbances in the model were normally distributed.  This is a very important assumption because otherwise hypothesis testing to check the statistical significance of variables in the model (i.e. through t-tests) would be useless.  The model in its simplest form says the difference between the actual rate of change of real aggregate output in time period t and the trend rate of the change of supply is equal to the difference between the realized price level in time period t and the expected price level in time period tplus an error term.  The forecasted error term in time period t-1 given the expected price level in time thas to be assumed to be zero because if that forecasted error term isn’t zero, then the actual output Yt will be different than the forecast, which will make it a useless tool for policymakers and firms (Kantor 1979, 1425).

Later on, these rational expectations were tested on other markets, such as the capital market.  It is from the rational expectations breakthrough that the Efficient Market hypothesis is born.  To remind everybody of that hypothesis, it claims that in an efficient market, all information is known and the prices (i.e. stock prices) fully reflect all of that available information.  There are many who believe in the Efficient Market hypothesis, and if their assumptions are valid, then investors can only beat the market in the short run.  That is, in the long run, due to the perfect availability of information, there is no room to make a profit.  However, there are many who refute these beliefs and claim that in fact, there is no such thing as perfect information and it is not readily available to all consumers.

Later in the article, Kantor does say that the major contribution that Keynes makes to economics is the understanding that the “basis of choice lies in vague, uncertain and shifting expectations of future events,” but he neither describes nor attempts to incorporate these expectations into a model.  According to Ludwig Lachmann, the incorporation of expectations by a business man is no different than a scientist attempting to prove a hypothesis.  “Both [business man and scientist] reflect an attempt at cognition and orientation in an imperfectly known world, both embody imperfect knowledge to be tested and improved by later experience.”  This is very true.  Economists are constantly refining models to more accurately reflect observations of trends in the real world.  These lagged models were tested in several situations, including Jacob A. Frenkel’s test for the demand for money during Germany’s hyperinflation era.  He found that people incorporated inflationary expectations into their demand for money.

Lastly, these lagged models used both autoregressive (lagging one variable)  and moving average parts (incorporating lags of other variables into the model) to better account for consumers’ expectations.  Robert E. Hall is one example.  He looked at the life-cycle and permanent-income hypotheses and found that consumption that is lagged one period can help predict current consumption because it is shown that “expectations of future marginal utility is a function of today’s level of consumption alone.”  Nevertheless, the one shortcoming that needs to be realized, which is apparent in forecasts for employment levels, is the fact that random shocks are real or nominal, as well as temporary or permanent.  Thus, due to the inability for people to determine which category the shock belongs in, forecasts go astray because these effects could not be anticipated.

 Source: Kantor, Brian.  1979.  Rational expectations and economic thought.  Journal of Economic Literature 17, no. 4 (December): 1422-1441.

A Response to Friedman’s “The role of monetary policy”

Sunday, February 3rd, 2008

Milton Friedman’s article hopes to achieve two things–how can monetary policy contribute to the business cycle and how it should be conducted so that it is the most effective.  Friedman makes the readers aware from the start that Keynes recognized that the monetary policy in place in the 1920s could do little to mitigate the Great Depression because it was a useful tool to stop inflation, but would have done little to curb the recession.  During Keynes time of the Great Depression, he also realized that the liquidity preference for holding money was much higher during times of unemployment, but little could be done in way of monetary policy.  That is where he realized the benefits of government spending to make up for “insufficient private investment” due to the higher interest rates.  It wasn’t until after WWII when monetary policy was realized to be “potent” (as Friedman puts it) because of the inflation sparked by the “cheap money policies.”

In the article, Friedman strongly suggests that the Great Depression, or the Great Contraction as he calls it in this article, was brought on in great part due to the Federal Reserve engaging in deflationary policies, which contracted the money supply by one-third.  Essentially, the Federal Reserve failed to provide liquidity to the banking system.   In Friedman’s era, the role of monetary policy is to promote full employment first and foremost.  Second in the objectives of monetary policy is the prevention of inflation.  However, Friedman feels that the role of the Federal Reserve and monetary policy may be too vast–that is, perhaps the Federal Reserve can’t take on such a big challenge.

Two limitations that monetary policy have a hard time addressing are pegging interest rates for a long period of time as well as pegging unemployment for a long period of time.  Rather than letting the U.S. government pegging war and post-war bonds at a certain price, which turned out to be a mistake, the Fed should engage in open market operations by buying and selling securities.  Of particular concern is a way to keep interest rates low–meaning that the Fed should buy securities to make more money available for banks to loan out.  Friedman recognizes that by allowing the Fed to engage in open market operations, there would be a cyclical adjustment period because as the story goes, if there is more money in the economy, more people will be spending money, which in turn will lead to higher real wages and eventually higher prices.  This would cause spending to decrease and interest rates will have to return to a higher level in perhaps one to two years.  An interesting point that Friedman makes is the country comparison to interest rate levels.  He notes that countries that have higher interest rates have looser monetary policies in place than those countries that have lower interest rates.  This has to do with the fact that outrageous inflation levels have to be curbed by higher interest rates, but in order to achieve those high inflation levels in the first place, the central banking system of that country had to be irresponsible by trying to stimulate growth or “patch up a debt” through the printing of money.  The second limitation that Friedman discusses is the level of pegged unemployment in the long run.  Friedman asks why monetary policy cannot peg the unemployment at a consistent level, say three percent (which is his example).  The reason being is the same reason as pegging interest rates in the long run–in the long run the economy will react to those subsequent policies, but those reactions will be lagged and delayed.  Excess supply or demand will force the real wage rate lower and higher, respectively, than would otherwise be experienced in a state of equilibrium.  (An interesting note about the wage rate is Friedman’s argument regarding minimum wage rates and the strength of labor unions, all of which make the natural rate of unemployment higher than the market would otherwise dictate.)

One thing that Friedman stresses is that monetary policy, though it sounds negative, may prevent money from being a “source of economic disturbance.”  Essentially, the Great Contraction may have occurred on a lesser scale or not at all if deflationary measures weren’t used by the Federal Reserve System.  The second thing that monetary policy can do that will help the economy is to keep it running, to keep it “well oiled.”  That is to say, monetary policy can ensure price stability, which is important for consumers and businesses alike because they will consume more rationally and predictably if the economy is presumed to be stable.  Lastly, monetary policy works as a countermeasure.  For example, if there are presumed federal budget deficits–which means an increased spending–then monetary policy could work to offset the expected increases in inflation.

 When looking at how monetary policy should be conducted, there are two responsibilities: controlling factors in the environment that it can more easily control (i.e. price level) and stay away from those that it has a harder time controlling (i.e. unemployment levels) and avoiding “sharp swings” in policy (i.e. over correcting the market by being too expansionary and too contractionary).  All in all, short of publicly stating a fixed monetary growth, stable monetary policy is needed to promote economic stability.  However, Friedman does recognize the shortcoming, which is sometimes unavoidable–that is, there are other exogenous factors that will influence the domestic economy (i.e. exchange rates, currency markets, and foreign economic trends).

Source: Friedman, Milton.  1968.  The role of monetary policy.  American Economic Review 58 (March): 1-17.  (This can be found in Snowdon’s Macroeconomic Reader.)