Introducing the Sticky-Price Model: Checkpoint of Chapter 9 of Next Edition of Marty Olney's and My Macro Textbook

Weekend Reading: Robert Solow: A Theory Is a Sometime Thing

Robert Solow: A theory Is a Sometime Thing: "Milton Friedman... aims to undermine the eclectic American Keynesianism of the 1950s and 1960s... goes after two... lines of thought. His first claim is that the central bank, the Fed, cannot ‘peg’ the real interest rate... to undermine the standard LM curve.... The Fed can peg the nominal federal funds rate, but not the real rate...

..."These… effects will reverse the initial downward pressure on interest rates fairly promptly, say, in something less than a year. Together they will tend, after a somewhat longer interval, say, a year or two, to return interest rates to the level they would otherwise have had" (Friedman 1968, p. 6). Now we know what ‘peg’ means.... The goal, remember, is to contradict the eclectic American Keynesian... which did not, after all, require the Fed to control real interest rates forever. If the Fed can have meaningful influence only for less than a year or two, then it is surely playing a losing game, especially in view of those ‘long and variable lags.’ Is that really so?...

After Paul Volcker's appointment... the real funds rate had been fluctuating around zero... rose sharply to about 5 percent and fluctuated around that level for the next six years.... This sustained 5 percentage point increase in the real funds rate was... a deliberate intervention, designed to end the ‘double-digit’ inflation of the early 1970s, and it did so, with real side-effects. This chain of events could not have worked through any ‘misperception’ mechanism; there was no secret about what the Volcker Fed was doing. So the Fed was in fact able to control (‘peg’) its real policy rate, not for a year or two but for at least six years, certainly long enough for the normal conduct of counter-cyclical monetary policy to be effective.... The difference between ‘a year or two’ and ‘half a dozen years’ is not a small matter. This part of Friedman's demolition project seems to have failed as pragmatic economics, although it may have succeeded in persuading the economics profession.

The second, and even more striking, contribution of the 1968 presidential address was Friedman's introduction of the ‘natural rate of unemployment’ along with the long-run vertical Phillips curve and its accelerationist implications.... I do not have to repeat Friedman's classic discussion of the consequences if the Fed (or anyone) attempts to push the actual unemployment rate below the natural rate: higher monetary growth, at first increased spending, output and employment, as prices adjust with a lag to the new state of demand. But eventually the rate of inflation, whatever it was before, increases and this gets built into expectations.... So the Fed has to create even faster monetary growth to sustain the lower unemployment rate, and you know the rest. Once again, we can imagine such a world; Friedman's claim is that we live in it.... For a brief period in the 1970s and early 1980s, this simple model seemed to do well: if you plot the change in the inflation rate against the unemployment rate (see Modigliani and Papademos 1975), you get a decent downward-sloping scatter that crosses the u-axis at a reasonably defined natural rate or NAIRU). At other times, not so much....

Olivier Blanchard (2016).... First, there is still a Phillips curve... Second, expectations of inflation have become more and more ‘anchored’.... Third, the slope of the Phillips curve itself has been getting flatter, ever since the 1980s, and is now quite small. And last, the standard error around the Phillips curve is large; the relationship is not well defined in the data. Taken together, these last two findings imply that there is no well-defined natural rate of unemployment, either statistically or conceptually.... This is very different from the story told so confidently and fluently in the 1968 address.

My mind kept returning to a famous line of dramatic verse: was this the face that launched a thousand ships?... Milton Friedman's presidential address... may not have burnt the topless towers of Ilium, but it certainly helped lead macroeconomics to its current state of refined irrelevance. The financial crisis and the recession that followed it may have planted some second thoughts, but even that is not certain. A few major failures like those I have registered in this note may not be enough for a considered rejection of Friedman's doctrine and its various successors. But they are certainly enough to justify intense skepticism, especially among economists, for whom skepticism should be the default mental setting anyway. So why did those thousand ships sail for so long, why did those ideas float for so long, without much resistance? I don't have a settled answer.

One can speculate. Maybe a patchwork of ideas like eclectic American Keynesianism, held together partly by duct tape, is always at a disadvantage compared with a monolithic doctrine that has an answer for everything, and the same answer for everything. Maybe that same monolithic doctrine reinforced and was reinforced by the general shift of political and social preferences to the right that was taking place at about the same time. Maybe this bit of intellectual history was mainly an accidental concatenation of events, personalities, and dispositions. And maybe this is the sort of question that is better discussed while toasting marshmallows around a dying campfire.

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