-The end of the Neoclassical Synthesis (or “Keynesian” IS-LM) period.
1- What was the economic event that put an end to the Neoclassical Synthesis? Why?
Stagflation (higher inflation and higher unemployment) because it contradicted the Phillips curve that was an essential part of the Neoclassical Synthesis: expansionary policy did not lead to any improvement in unemployment and actually worsened the economic situation.
2- What is the Phillips curve?
Empirical relationship between Un and inflation that was transformed into a theoretical relationship: It was assumed that there is a stable inverse relationship between unemployment and inflation so it is possible to fine-tune the economy (inflationary policy leads to lower unemployment and inversely).
3- What alternative explanation of this economic event were Monetarists able to provide?
a. Describe the basic hypotheses of their model.
The basis hypotheses assumed are that the labor supply depends on expected real wage (w/E(P)) and that workers form their expectations in an adaptive way, that is they only look at and correct for the past (no tentative to project themselves in the future).
b. What is the augmented Phillips curve? How is it different from the traditional Philips curve?
The augmented Phillips curve augments the traditional Phillips curve with expectations of inflation. = f(Un) + E( ). The traditional Phillips curve does not take into account expectations of inflation.
c. What is the NAIRU? (i.e. what does it means? And what theoretical implications does it have?)
The NAIRU is the Non-Accelerating-Inflation Rate of Unemployment. It is the rate of unemployment below which price growth accelerate (i.e. inflation rises) without any effect on unemployment. Theoretically it is the unemployment rate generated by a free market economy due to structural unemployment.
d. Describe the dynamics of the monetarist model: assuming a loosening of monetary policy in time 2, how do we go from point a to point b? from point b to point c?
Loosening of monetary policy: ∆M > 0 or ∆m > 0 (level or rate of growth of the money supply increases)
Point a to point b:
- At time 1 we are at point a where E( ) = , thus workers do not make any error of expectation.
- At time 2 the loosening of monetary policy leads to point b because
It affects inflation: Following the QTM in growth terms, Δm > 0 Δ ( → )
It affects unemployment: Higher inflation leads to lower real wage and so higher demand for labor (ΔLd > 0). However the supply of labor is unchanged because, at first, w/E(P) is unchanged. Indeed E( ) = + α( - E( )) E( ) = . There is thus an excess demand for labor Ld > Ls which leads to a rise in wage and so w/E(P)) and so Ls. Thus employment increases (and so unemployment decreases).
Point b to point c:
- At time 3, workers figure out they were wrong: E( ) = + α( - E( )) E( ) = + α( - ) > E( ). Thus expected real wage decreases: w/E( ) < w/E( ) = w/E( ), and so the labor supply decreases, leading to higher unemployment.
- The process of adjustment continues until time 4 where again, because we are at the NAIRU: E( ) = . Note that = because the central bank did not change anything anymore.
e. Implications in terms of economic policy
All this implies that economic policies (here via the central bank) only have very temporary beneficial effects. In the long-run, you always go back to the NAIRU but with a worse situation in terms of inflation, so there is no point to have active monetary policy once the economy is at the NAIRU. The point is that, because of free market economy, the economy is usually already at the NAIRU, so there is no point of active policy in the first place.
4- How can the NAIRU be criticized?
Very hard to measure and so hard to use for policy purpose: how do you know if you are at the NAIRU or above it?
Theoretically it is endogenous (structural