Milton Friedman on how New Keynesian Macroeconomics is mostly monetarism
06 Feb 2015 Leave a comment
The success of monetarism and the death of the correlation between monetary growth and inflation
30 Jan 2015 1 Comment
in business cycles, econometerics, economics of bureaucracy, economics of information, inflation targeting, macroeconomics, Milton Friedman, monetarism, monetary economics, politics - Australia, politics - New Zealand, politics - USA Tags: lags on monetary policy, Levis Kochin, monetary policy
Monetarists blame fluctuations in inflation on excessively volatile growth in monetary aggregates. In 1982, Friedman defined monetarism in an essay on defining monetarism as follows:
Like many other monetarists, I have concluded that the most important thing is to keep monetary policy from doing harm.
We believe that a steady rate of monetary growth would promote economic stability and that a moderate rate of monetary growth would prevent inflation
The U.S. data supported this hypothesis about the volatility of monetary growth and inflationuntil 1982, but since 1983 monetary aggregates have been essentially uncorrelated with subsequent inflation in the U.S.
Levis Kochin pointed out in 1979 that a well designed monetary policy would lead to zero correlation between any measure of monetary policy and subsequent inflation. The reason for this is the correlation between any variable and a constant is zero.
If monetary growth is stable, say, a constant growth rate of 4% per year, as advocated by Milton Friedman, monetary growth will have no correlations with any variable:
Poole (1993, 1994) and Tanner (1993) also argue that one predictable consequence of optimal monetary policy is that the correlation between monetary policy instruments and policy goals will be driven to zero.
Poole further contends that it is obvious to any careful reader of Theil (1964) that optimally variable policy will give rise to a zero correlation between policy and goal variable…
In 1966 Alan Walters, a U.K. monetarist, observed:
If the [monetary] authority was perfectly successful then we should observe variations in the rate of change of the stock of money but not variations in the rate of change of income… [a]ssuming that the authority’s objective is to stabilize the growth of income.
Milton Friedman in 2003, wrote about how the Fed acquired a good thermostat:
The contrast between the periods before and after the middle of the 1980s is remarkable.
Before, it is like a chart of the temperature in a room without a thermostat in a location with very variable climate; after, it is like the temperature in the same room but with a reasonably good though not perfect thermostat, and one that is set to a gradually declining temperature.
Sometime around 1985, the Fed appears to have acquired the thermostat that it had been seeking the whole of its life…
Prior to the 1980s, the Fed got into trouble because it generated wide fluctuations in monetary growth per unit of output. Far from promoting price stability, it was itself a major source of instability as Chart 1 illustrates.
Yet since the mid ’80s, it has managed to control the money supply in such a way as to offset changes not only in output but also in velocity.
Nick Rowe explained the difficulty of causation and correlation under different policy regimes and Milton Friedman’s thermostat superbly as an econometric problem Nick Rowe:
If a house has a good thermostat, we should observe a strong negative correlation between the amount of oil burned in the furnace (M), and the outside temperature (V).
But we should observe no correlation between the amount of oil burned in the furnace (M) and the inside temperature (P). And we should observe no correlation between the outside temperature (V) and the inside temperature (P).
An econometrician, observing the data, concludes that the amount of oil burned had no effect on the inside temperature. Neither did the outside temperature. The only effect of burning oil seemed to be that it reduced the outside temperature. An increase in M will cause a decline in V, and have no effect on P.
A second econometrician, observing the same data, concludes that causality runs in the opposite direction. The only effect of an increase in outside temperature is to reduce the amount of oil burned. An increase in V will cause a decline in M, and have no effect on P.
But both agree that M and V are irrelevant for P. They switch off the furnace, and stop wasting their money on oil.
Subsequent work of Levis Kochin showed that if the effects of fluctuations in monetary aggregates were not precisely known then the optimal policy would produce negative correlations between monetary aggregates and inflation:
The negative correlation results from coefficient uncertainty because the less certain we are about the size of a multiplier, the more cautious we should be in the application of the associated policy instrument.
Therefore, although optimal policy leads to lack of correlation between the goal and control variables if the coefficient is known, it will lead to a negative relationship if there is coefficient uncertainty. The higher the uncertainty, the more cautious will be the optimal policy response. Also, if the control variable can’t be controlled perfectly then the correlation between the goal and the control variable becomes positive i.e., the control errors are random…
Uncertainty about the impact of a policy will stay the hand of any bureaucrat , much less a central banker, as Kochin and his co-author explain:
Uncertainty should lead to less policy action by the policymakers. The less policymakers are informed about the relevant parameters, the less activist the policy should be. With poor information about the effects of policy, very active policy runs a higher danger of introducing unnecessary fluctuations in the economy.
What influence did Milton Friedman have on 1980s and 1990s Australian monetary policy?
29 Jan 2015 3 Comments
in F.A. Hayek, Milton Friedman, monetarism, politics - Australia Tags: conspiracy theorists, conspiratorial left, inflation targeting, monetary policy, vast right-wing conspiracy
The Hayek and Friedman Monday conferences on the ABC in 1976 and 1975 are still ruling the Australian policy roost, if some of the Left over Left in Australia are to be believed. Milton Friedman is said to have mesmerised several countries with a flying visit with his Svengali powers of persuasion.
When working at the next desk to a monetary policy section in the Australian Prime Minister’s Department in the late 1980s, I heard not a word of Friedman’s Svengali influence:
• The market determined interest rates, not the Reserve Bank was the mantra for several years. Joan Robinson would have been proud that her 1975 Monday conference was still holding the reins.
• Monetary policy was targeting the current account. Read Edwards’ biography of Keating and his extracts from very Keynesian Treasury briefings to Keating signed by David Morgan that reminded me of Keynesian macro101.
When as a commentator on a Treasury seminar paper in 1986, Peter Boxhall – fresh from the US and 1970s Chicago educated – suggested using monetary policy to reduce the inflation rate quickly to zero, David Morgan and Chris Higgins almost fell off their chairs. They had never heard of such radical ideas.
In their breathless protestations, neither were sufficiently in-tune with their Keynesian educations to remember the role of sticky wages or even the need for the monetary growth reductions to be gradual and, more importantly, credible as per Milton Freidman and as per Tom Sargent’s end of 4 big and two moderate inflations papers in the early 1980s.
I was far too junior to point to this gap in their analytical memories about the role of sticky wages, and I was having far too much fun watching the intellectual cream of Treasury senior management in full flight. (I read Friedman & Sargent much later).
The competing visions of stabilisation policy have been defined by Franco Modigliani and Milton Friedman
26 Jan 2015 Leave a comment
in business cycles, economics of information, history of economic thought, macroeconomics, Milton Friedman, monetarism, monetary economics Tags: Franco Modigliani, Keynes in macroeconomics, monetary policy, stabilisation policy, The fatal conceit, The pretence to knowledge
Robert Lucas interview in Brazil, 2nd November 2012
24 Jan 2015 Leave a comment
in applied welfare economics, business cycles, comparative institutional analysis, development economics, economic growth, global financial crisis (GFC), great recession, growth disasters, growth miracles, inflation targeting, macroeconomics, monetarism, Robert E. Lucas Tags: Robert E. Lucas
The role of the introduction of a five day working week in Japan’s Lost Decade
13 Jan 2015 2 Comments
in business cycles, economic growth, economic history, labour economics, labour supply, macroeconomics, monetarism Tags: Japan, Japanese banking system, Lost Decade
When I lived in Japan between 1995 and 1997, they are undergoing the transition from a six-day week to a five day week. At the time, workers at my University had to show up on Saturday morning. They then went home at lunchtime. Saturday morning at the office was phased out a few years later.
In explanations of the Lost Decade of growth in Japan dating from the early 1990s, with the exception of Ed Prescott, the explanation that the Japanese simply chose to produce less per worker over the course of the 1990s does not figure highly.
The Japanese working week was reduced by law from 48 to 44 hours per week in 1988 and further reduced by the same labour standards law to 40 hours per week from 1993 (Prescott 1999; Hayashi and Prescott 2002). The Japanese stopped routinely working on Saturdays over the 1990s. The number of national holidays was increased by three and an extra day of annual leave was also prescribed by law.
Figure 1 shows this regulatory change about the length of the standard working week that started in 1987 was followed by a sharp drop in hours worked per working per working age Japanese over the period 1988 to 1993. The Japanese working age population is defined as those aged 20 to 69 (Hayashi and Prescott 2002).
Figure 1: Weekly hours worked per Japanese aged 20 to 69, 1970-2000
Source: Hayashi and Prescott 2002.
The regulatory process to end the standard six day working week in Japan straddled the start of the Lost Decade. This major change in the regulation of the supply of labour per week in the number of hours worked and the stagnation of GDP growth soon after could be more than a coincidence (Prescott 1999; Hayashi and Prescott 2002).
Americans work more hours a year than workers in Japan. But both work less than before. Data: buff.ly/1LhU5gH http://t.co/7oaGYKLRmk—
HumanProgress.org (@humanprogress) August 18, 2015
More employment did not fill the short-fall in weekly labour supply per worker after the introduction of the 44 hour week and then the 40 hour week in Japan. Many offices and factories closed on Saturday rather than employ more to make up the hours. The regulatory change was a clear cut constraint on the length of the working week that was hard to get around because of the need to recruit a separate set of workers to come in on Saturday afternoon and then all day Saturday.
During the transition to a five day working week, Japanese real GDP growth should slow down because output levels must taper during a transitional period because one day per week less in labour is supplied in production and capital is being worked for one day a week less than before (Prescott 1999; Hayashi and Prescott 2002).
Output per working age person depends on capital-labour ratios, on hours worked per week and on changes in total factor productivity due to factors such as technological progress and changes in institutions and economic policies.
The effects of the change in the length of the working week on output per working age Japanese will persist for a significant time because investment plans and the capital stock must also adjust to a shorter working week. This is another example of a highly persistent shock that can partly account for the Lost Decade. As Prescott (1999) observed:
Given the change in Japanese law and the resulting drop in normal market hours, growth theory predicts the almost stagnant output of the Japanese economy in the 1990s. This reduction in market hours lowered the marginal product of capital, making investment unprofitable.
Given the lack of profitable domestic investment opportunities, the Japanese began saving by investing abroad. This explains Japan’s large trade surpluses
…The Japanese economy in the 1990s is not as depressed as the U.S. economy was in the 1930s. Market hours in Japan in the 1990s have fallen only half as much as market hours fell in the United States during the Great Depression.
More importantly, the reduction in market hours in Japan in the 1990s was the stated objective of policy.
The reduction in weekly hours worked will also reduce the working week of capital because labour and capital are usually complementary inputs. The reduced length of the working week will see some existing capital producing less, some capital will go spare, and the rate of wear and depreciation will fall.
The drop in weekly hours worked will lower the marginal productivity of existing and new capital which will make new capital investments in Japan less profitable than before. Net investment will be less while the Japanese capital stock is adjusting down to the reduced working week for capital and labour.
Measured total factor productivity will fall because of an under-utilisation of a capital stock that is now larger than required for the available labour force. Net investment will decline by a large amount because investment demand is a small yearly addition to the capital stock.
For example, if annual investment demand is 5 per cent of the capital stock, and the desired capital stock becomes 1 per cent smaller than previous, annual net investment will fall 20 per cent. GDP growth will resume at the trend rate once the lower level of output per working age person is reached.
For those that still doubt, consider the contrary, what would you expect to happen in your country moved from five day week before day working week? Do you expect workers to produce as much as before? Britain was on a three day working week during the coal miners’ strike. As expected, output fell because the working week was shorter.
The main gap in the English language literature about the reduction in the working week in Japan is a lack of publications I can find by Japanese economists discussing what predictions of a made about the likely consequences for output, investment and productivity before the reduction in the length of working week was legislated. Did the reduction in the length of the working week in Japan turn out as planned and predicted before it was implemented?
France introduced a 35 hour week some years ago. Although there were various options for over time, albeit strictly regulated, a uniform prediction was that the 35 hour week would reduce productivity. The new workweek was phased in slowly, with large firms adopting it in February 2000 and smaller firms doing so only in January 2002.
French employees were expected to bear only a small part of the cost of the working-time reduction, continuing to earn roughly the same monthly income – in line with the unions’ slogan ’35 hours pays. To ease that transition, the law reduced the overtime premium for small firms and increased their annual limit on overtime work compared with large firms.
The reduction in the length of the French working week failed as work sharing strategy and reduced productivity. This was a fair summary by the IMF:
The 35-hour workweek appears to have had a mainly negative impact. It failed to create more jobs and generated a significant—and mostly negative—reaction both from companies and workers as they tried to neutralize the law’s effect on hours of work and monthly wages.
While it cannot be ruled out that individuals who did not change their behaviour because of the law became more satisfied with their work hours, simple survey measures do not show increased satisfaction.
Between 1997 and 2000, Quebec reduced its standard workweek from 44 to 40 hours to stimulate jobs growth – the old work sharing ideal. The Quebec policy contained no suggestion or requirement that employers provide wage increases to compensate workers for lost hours.
Despite a 20% reduction among full-time workers in weekly hours worked beyond 40, the policy failed to raise employment at the provincial level or within industries. If anything, there were job losses.
Japan was the only case where a reduction in the length of the working week met with wide approval by the public and people simply stopped working on Saturdays. The law succeeded simply because it did but it was designed to do: reduce the number of days existing workers worked. Japan was undergoing mild deflation at the time, so the need to reduce wages was minimal.
Annual hours worked per employed Japanese has continued to slowly taper down since the late 1990s, which may be a further explanation of its continual slow growth.
David Andolfatto wrote a nice paper explaining the consequences for the financial and monetary sectors of this reduction in the length of the Japanese working week:
- a steady decline in bank lending;
- the money multiplier declines;
- nominal interest rates that are close to zero; and
- massive infusions of liquidity by the Bank of Japan that seem to have no effect at all.
In his analysis, David Andolfatto referred generally to a productivity slowdown as discussed by Prescott rather than to the specifically to the reduction in the length of the Japanese working week. Nothing detracts in his analysis, as Andolfatto said, that Japan has a problem: lagging productivity growth and as Andolfatto concluded:
…monetary and fiscal policies, or reforms directed exclusively at the banking sector, are unlikely to re-establish productivity growth. What is likely needed are economy-wide reforms that enhance the willingness and ability of individuals to adopt potentially disruptive technological advancements and work practices.
Interview with Robert Lucas on the global financial crisis and the great recession
17 Dec 2014 Leave a comment
in budget deficits, business cycles, economic growth, fiscal policy, global financial crisis (GFC), great depression, great recession, macroeconomics, monetarism, monetary economics Tags: bank runs, GFC, great depression, great recession, Robert E. Lucas
Milton Friedman’s plucking model of the business cycle
15 Dec 2014 Leave a comment
in macroeconomics, Milton Friedman, monetarism, monetary economics Tags: Austrian business cycle theory, Austrian macroeconomics, business cycle asymmetry, Milton Friedman, plucking model, Roger Garrison
Friedman (1993) proposed a model of the depth of recessions and steepness of recoveries built on two empirical regularities:
- output is on average below a ceiling defined by supply capacity and tends back to this ceiling; and
- large contractions are followed by large expansions and mild contractions are followed by mild expansions.
The strength of a recovery should be positively correlated with depth of the recession but there should be no correlation between expansions and recessions (Friedman 1993; Alchian 1969).
Figure 1 illustrates Friedman’s model, which likens the time path of output to a string on the underside of an upward sloping board that is plucked downward at random intervals to various extents into busts that are followed by booms.
Figure 1: Friedman’s plucking model of the economic fluctuations
Source: Garrison (1996).
The upward sloping board plotted as a thick line in Figure 6 represents a ceiling on feasible output and employment in a given year that is set by resource and technology availabilities. The upward slope of this board accounts for trend real GDP growth over time due to technological progress and other factors.
Output is close to the ceiling shown in Figure 6 except for every now and then when it is plucked downwards by a monetary contraction.
There is no floor on these contractions in output to moderate the depth and violence of contractions, so some recessions are deep and sharp (Hansen and Prescott 2005; Friedman 1993; Goodwin and Sweeney 1993; Sichel 1993).
Contraction depth can vary greatly as is shown by the minor, mild and deep recessions in Figure 1. In each episode of plucking illustrated in Friedman’s model in Figure 1, the rebound mirrors the previous fall in output, but the recovery cannot go beyond the ceiling.
Friedman’s model is a bust-boom model of business cycle fluctuations. The business cycle starts with a bust caused by an adverse policy or other shock and is then followed by a boom as the market self-adjusts and the policy errors are reversed.
Without the initial adverse policy or other shock, there would neither be a bust nor a boom. The economy would track close to the ceiling on output and employment as is shown in Figure 1 by the periods between the plucks.
The correlation between busts and booms arises from the monetary contraction that caused the bust eventually inducing an offsetting correction in monetary policy.
The monetary contraction that pushed or plucked output below the upward sloping ceiling is later followed by a monetary expansion that offset the earlier contraction.
With the amplitude of monetary expansions correlated to offset the prior contractions, GDP growth will have similar plucks or falls and rebounds to the upward sloping output ceiling because of the link albeit with a lag between monetary growth and output fluctuations.
The increases and decreases in monetary growth are independent policy choices with unique causes.
The associated upward and downward movements in GDP growth are not correlated with each other but should be correlated with the prior fluctuations in monetary growth.
There would not be a bust and later boom if there is no monetary contraction to start the cycle. This is why Friedman (1993) proposed that the depths of busts are unrelated to duration and strength of prior economic booms. This upset Austrians such as Roger Garrison:
…Austrians work at a lower level of aggregation in order to allow for the outputs of the two sectors to move relative to one another and even to allow for differential movements within the investment-goods sector…
During a credit-induced boom, investment in the relatively high stages of production is excessive in that resources are drawn away (by an artificially low rate of interest) from the relatively low stages of production and from the final stage, consumption.
The decrease in the amount of resources allocated to the low and final stages is forced saving; the misallocation of resources from low to high stages is malinvestment.
Empirically, a credit-induced boom would be but weakly reflected in the conventional investment aggregate and hardly at all in the Monetarists’ output aggregate, which includes consumption.
The boom for the Austrians refers to something going on largely within the output aggregate.
It is represented in Friedman’s plucking model not by a conspicuous recovery to trend but rather by some period preceding a pluck which Friedman, operating at a higher level of aggregation, presumes to be healthy growth.
The publication of Milton Friedman’s paper in 1993, which recalled an obscure paper he wrote in 1964, lead to a large literature blossoming under the heading business cycle asymmetry.
Milton Friedman – Abolish The Fed
13 Dec 2014 Leave a comment
in macroeconomics, Milton Friedman, monetarism, monetary economics Tags: Milton Friedman, The Fed
Utopia, you are standing in it! 
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