Laidler on Friedman’s puzzling views on the Phillips Curve
Last weekend I attended a conference on Karl Brunner. It was a treat meeting a number of famous monetarists, particularly Bennett McCallum, who I described last year as my favorite monetary economist. One of the conference readings was written by David Laidler, an outstanding monetary historian. Anyone interested in learning about the development of macro theory between 1900 and 1940 should read his two books on the subject.
I was struck by the following passage in the Laidler article, which describes an inconsistency in Friedman’s view of the Phillips Curve (or aggregate supply curve.) The passages in quotation marks were written by Friedman, the other portions are Laidler:
Once inflation got going in response to monetary expansion,
“Employees will start to reckon on rising prices of things they buy and to demand higher nominal wages for the future. ‘Market’ unemployment is below the ‘natural’ level. There is an excess demand for labor so real wages will tend to rise toward their initial level.” (1968, p. 104, italics added.)
This story of a market out of equilibrium is of course quite compatible with Friedman’s earlier observation that, after an unanticipated monetary shock, “To begin with, much or most of the rise in income will take the form of an increase in output and employment rather than prices.” (1968 p. 103), but less so with another remark that occurs in an intervening paragraph.
“Because selling prices of products typically respond to an unanticipated rise in nominal demand faster than prices of factors of production, real wages received have gone down — though real wages anticipated by employees went up . . . Indeed, the simultaneous fall ex post in real wages to employers and rise ex ante to employees is what enable employment to increase.” (1968 pp. 103-104, italics added)
Here the behaviour of a key real variable, employment, is presented as an equilibrium response to price changes that have already occurred, but have been perceived differently on different sides of the market. It is hard to see how the employment change in question could simultaneously have precededthose same price changes. What we have in this passage, then, is not an alternative description of a disequilibrium interpretation of the Phillips curve augmented by the idea of inflation expectations, but something rather closer to Lucas’s alternative aggregate supply curve interpretation, albeit without the idea of rational expectations.
This sounds like Irving Fisher’s view of the Phillips curve, which I have always preferred to the NAIRU approach. A few lines later, Laidler quotes another passage that confirms this is what Friedman had in mind.
“There was, however, a crucial difference between Fisher’s analysis and Phillips’, between the truth of 1926 and the error of 1958, which had to do with the direction of causation. Fisher took the rate of change of prices to be the independent variable that set the process going.” (1975 p. 12 italics in original)
I think both Friedman and I visualize the process in terms of nominal shocks having real effects. In contrast, many Keynesians see inflation as resulting from an overheated economy. So who’s right? I do see why Laidler is critical of Friedman; he also claims that demand shocks initially produce higher output, and only later do prices rise.
I see a three step process. A monetary shock (money supply or demand) causes flexible asset prices to change immediately (stocks, commodities, exchange rates, etc.) This causes output to rise, and consumer prices and wages respond with a lag.
Recently I seem to see advantages to NGDP almost everywhere I look. (Yes, I know; confirmation bias.) I think Friedman made a mistake focusing on inflation. His nominal aggregate should have been NGDP, not the price level. In that case the nominal shock is an unexpected change in NGDP, and the real effect is a change in employment. Inflation doesn’t have to play any causal role in the story. This avoids the inconsistency of claiming prices are slow to rise, yet rising prices cause employment to change. NGDP can rise almost immediately, even if many prices are sticky. And we can model wages as responding with a lag to NGDP, not to prices. Of course this is exactly what happens in the real world—otherwise we would have seen wages soaring in 2007-08, when inflation shot up, but NGDP growth remained subdued.
So unexpected changes in NGDP are the nominal shock and (because wages and prices are sticky) employment responds to these nominal shocks in the short run, and then moves back to the natural rate in the long run. A very Fisherian approach, which does not need to rely on awkward assumptions about inflation only occurring at full employment, and which avoids the logical inconsistencies involved in using the price level as the indicator of nominal shocks.
In the next post I’ll use these ideas to address an issue raised in a recent Krugman post; is it possible to produce moderate inflation expectations in a liquidity trap?
PS. The Laidler and Friedman quotations were from “Some Aspects of Monetarism Circa 1970: A View from 1994.” In Macroeconomics in Retrospect: The Selected Essays of David Laidler.