Archive for September, 2019

Stigler Confirms that Wicksteed Did Indeed Discover the Coase Theorem

The world is full of surprises, a fact with which rational-expectations theorists have not yet come to grips. Yesterday I was surprised to find that a post of mine from May 2016, was attracting lots of traffic. When published, that post had not attracted much attention, and I had more or less forgotten about it, but when I quickly went back to look at it, I recalled that I had thought well of it, because in the process of calling attention to Wicksteed’s anticipation of the Coase Theorem, I thought that I had done a good job of demonstrating one of my favorite talking points: that what we think of as microeconomics (supply-demand analysis aka partial-equilibrium analysis) requires a macrofoundation, namely that all markets but the one under analysis are in equilibrium. In particular, Wicksteed showed that to use cost as a determinant of price in the context of partial-equilibrium analysis, one must assume that the prices of everything else have already been determined, because costs don’t exist independently of the prices of all other outputs. But, unfortunately, the post went pretty much unnoticed. Until yesterday.

After noticing all the traffic that an old post was suddenly receiving, I found that the source was Tyler Cowen’s Marginal Revolution blog, a link to my three-year-old post having been included in a post with five other links. I was curious to see if readers of Tyler’s blog would react to my post, so I checked the comments to his post. Most of them were directed towards the other links that Tyler included, but there were a few that mentioned mine. None of the comments really engaged with my larger point about Wicksteed; most of them focused on my claim that Wicksteed had anticipated the Coase Theorem. Here’s the most pointed comment, by Alan Gunn.

If Wicksteed didn’t mention transaction costs, he didn’t discover the Coase theorem. The importance of transaction costs and the errors economists make when they ignore them are what make Coase’s work important. The stuff about how initial assignment of rights doesn’t matter if transaction costs are zero is obvious and trivial.

A bit later I found that Scott Sumner, whose recent post on Econlib was also linked to by Tyler, added a comment to my post that more gently makes precisely a point exactly opposite of Alan Gunn’s.

Very good post. Some would argue that the essence of the Coase Theorem is not that the initial distribution of property rights doesn’t matter, but rather that it doesn’t matter if there are no transactions costs. I seem to recall that that was Coase’s view.

I agree with Scott that the essential point of the Coase Theorem is that if there are zero transactions costs, the initial allocation doesn’t matter. To credit Wicksteed with anticipating the Coase Theorem, you have to assume that Wicksteed understood that transactions costs had to be zero. But the zero transactions costs assumption was the default assumption. The question is then whether the observation that the final allocation is independent of the initial allocation is a real discovery even if the assumption of zero transactions cost is made only implicitly. Wicksteed obviously did make that assumption, because his result would not have followed if transactions costs were zero. Articulating explicitly an assumption that was assumed implicitly is important, but the substance of the argument is unchanged.

I can’t comment on what Coase’s view of his theorem was, but Stigler clearly did view the Theorem to refer to a situation in which transactions costs were zero. And it was Stigler who attached the name Coase Theorem to Coase’s discovery, and he clearly thought that it was a discovery because the chapter in Stigler’s autobiography Memoirs of an Unregulated Economist in which he recounts the events surrounding the discovery of the Coase Theorem is entitle “Eureka!” (exclamation point is Stigler’s).

The chapter begins as follows:

Scientific discoveries are usually the product of dozens upon dozens tentative explorations, with almost as many blind alleys followed too long. The rare idea that grows into a hypothesis, even more rarely overcomes the difficulties and contradictions it soon encounters. An Archimedes who suddenly has a marvelous idea and shouts “Eureka!” is the hero of the rarest of events. I have spend all of my professional life in the company of first-class scholars but only once have I encountered something like the sudden Archimedian revelation – as an observer. (p. 73)

After recounting the history of the Marshallian doctrine of external economies and its development by Pigou into a deviation between private and social costs, Stigler continues:

The disharmonies between private and social interests produced by external economies and diseconomies became gospel to the economics profession. . . . When, in 1960, Ronald Coase criticized Pigou’s theory rather casually, in the course of a masterly analysis of the Federal Communications Commission’s work, Chicago economists could not understand how so fine an economist as Coase could make so obvious a mistake. Since he persisted [he persisted!], we invited Coase . . . to come and give a talk on it. Some twenty economists from the University of Chicago and Ronald Coase assembled one evening at the home of Aaron Director. Ronald asked us to assume, for a time, a world without transactions costs. That seemed reasonable because economists . . .  are accustomed . . . to deal with simplified . . . “models” and problems. . . .

Ronald asked us to believe . . . [that] whatever the assignment of legal liability for damages, or whatever assignment of legal rights of ownership, the assignments would have no effect upon the way economic resources would be used! We strongly objected to this heresy. Milton Friedman did most of the talking, as usual. He also did much of the thinking, as usual. In the course of two hours of argument the vote went from twenty against and one for Coase to twenty-one for Coase. What an exhilarating event! I lamented afterward that we had not the clairvoyance to tape it (pp. 74-76)

Stigler then summarizes Coase’s argument and proceeds to tell his understanding of the proposition that he called the Coase Theorem.

This proposition, that when there are no transactions costs the assignments of legal rights have no effect upon the allocation of resources among economic enterprises, will, I hope, be reasonable and possibly even obvious once it is explained. Nevertheless there were a fair number of “refutations” published in the economic journals. I christened the proposition the “Coase Theorem” and that is how it is known today. Scientific theories are hardly ever named after their first discoverers . . . so this is a rare example of correct attribution of a priority.

Well, not so much. Coase’s real insight was to see that all economic exchange involves an exchange of rights over resources rather than over the resources themselves. But the insight that the final allocation is independent of the initial allocation was Wicksteed’s.


What’s Wrong with DSGE Models Is Not Representative Agency

The basic DSGE macroeconomic model taught to students is based on a representative agent. Many critics of modern macroeconomics and DSGE models have therefore latched on to the representative agent as the key – and disqualifying — feature in DSGE models, and by extension, with modern macroeconomics. Criticism of representative-agent models is certainly appropriate, because, as Alan Kirman admirably explained some 25 years ago, the simplification inherent in a macoreconomic model based on a representative agent, renders the model entirely inappropriate and unsuitable for most of the problems that a macroeconomic model might be expected to address, like explaining why economies might suffer from aggregate fluctuations in output and employment and the price level.

While altogether fitting and proper, criticism of the representative agent model in macroeconomics had an unfortunate unintended consequence, which was to focus attention on representative agency rather than on the deeper problem with DSGE models, problems that cannot be solved by just throwing the Representative Agent under the bus.

Before explaining why representative agency is not the root problem with DSGE models, let’s take a moment or two to talk about where the idea of representative agency comes from. The idea can be traced back to F. Y. Edgeworth who, in his exposition of the ideas of W. S. Jevons – one of the three marginal revolutionaries of the 1870s – introduced two “representative particulars” to illustrate how trade could maximize the utility of each particular subject to the benchmark utility of the counterparty. That analysis of two different representative particulars, reflected in what is now called the Edgeworth Box, remains one of the outstanding achievements and pedagogical tools of economics. (See a superb account of the historical development of the Box and the many contributions to economic theory that it facilitated by Thomas Humphrey). But Edgeworth’s analysis and its derivatives always focused on the incentives of two representative agents rather than a single isolated representative agent.

Only a few years later, Alfred Marshall in his Principles of Economics, offered an analysis of how the equilibrium price for the product of a competitive industry is determined by the demand for (derived from the marginal utility accruing to consumers from increments of the product) and the supply of that product (derived from the cost of production). The concepts of the marginal cost of an individual firm as a function of quantity produced and the supply of an individual firm as a function of price not yet having been formulated, Marshall, in a kind of hand-waving exercise, introduced a hypothetical representative firm as a stand-in for the entire industry.

The completely ad hoc and artificial concept of a representative firm was not well-received by Marshall’s contemporaries, and the young Lionel Robbins, starting his long career at the London School of Economics, subjected the idea to withering criticism in a 1928 article. Even without Robbins’s criticism, the development of the basic theory of a profit-maximizing firm quickly led to the disappearance of Marshall’s concept from subsequent economics textbooks. James Hartley wrote about the short and unhappy life of Marshall’s Representative Firm in the Journal of Economic Perspectives.

One might have thought that the inauspicious career of Marshall’s Representative Firm would have discouraged modern macroeconomists from resurrecting the Representative Firm in the barely disguised form of a Representative Agent in their DSGE models, but the convenience and relative simplicity of solving a DSGE model for a single agent was too enticing to be resisted.

Therein lies the difference between the theory of the firm and a macroeconomic theory. The gain in convenience from adopting the Representative Firm was radically reduced by Marshall’s Cambridge students and successors who, without the representative firm, provided a more rigorous, more satisfying and more flexible exposition of the industry supply curve and the corresponding partial-equilibrium analysis than Marshall had with it. Providing no advantages of realism, logical coherence, analytical versatility or heuristic intuition, the Representative Firm was unceremoniously expelled from the polite company of economists.

However, as a heuristic device for portraying certain properties of an equilibrium state — whose existence is assumed not derived — even a single representative individual or agent proved to be a serviceable device with which to display the defining first-order conditions, the simultaneous equality of marginal rates of substitution in consumption and production with the marginal rate of substitution at market prices. Unlike the Edgeworth Box populated by two representative agents whose different endowments or preference maps result in mutually beneficial trade, the representative agent, even if afforded the opportunity to trade, can find no gain from engaging in it.

An excellent example of this heuristic was provided by Jack Hirshleifer in his 1970 textbook Investment, Interest, and Capital, wherein he adapted the basic Fisherian model of intertemporal consumption, production and exchange opportunities, representing the canonical Fisherian exposition in a single basic diagram. But the representative agent necessarily represents a state of no trade, because, for a single isolated agent, production and consumption must coincide, and the equilibrium price vector must have the property that the representative agent chooses not to trade at that price vector. I reproduce Hirshleifer’s diagram (Figure 4-6) in the attached chart.

Here is how Hirshleifer explained what was going on.

Figure 4-6 illustrates a technique that will be used often from now on: the representative-individual device. If one makes the assumption that all individuals have identical tastes and are identically situated with respect to endowments and productive opportunities, it follows that the individual optimum must be a microcosm of the social equilibrium. In this model the productive and consumptive solutions coincide, as in the Robinson Crusoe case. Nevertheless, market opportunities exist, as indicated by the market line M’M’ through the tangency point P* = C*. But the price reflected in the slope of M’M’ is a sustaining price, such that each individual prefers to hold the combination attained by productive transformations rather than engage in market transactions. The representative-individual device is helpful in suggesting how the equilibrium will respond to changes in exogenous data—the proviso being that such changes od not modify the distribution of wealth among individuals.

While not spelling out the limitations of the representative-individual device, Hirshleifer makes it clear that the representative-agent device is being used as an expository technique to describe, not as an analytical tool to determine, intertemporal equilibrium. The existence of intertemporal equilibrium does not depend on the assumptions necessary to allow a representative individual to serve as a stand-in for all other agents. The representative-individual is portrayed only to provide the student with a special case serving as a visual aid with which to gain an intuitive grasp of the necessary conditions characterizing an intertemporal equilibrium in production and consumption.

But the role of the representative agent in the DSGE model is very different from the representative individual in Hirshleifer’s exposition of the canonical Fisherian theory. In Hirshleifer’s exposition, the representative individual is just a special case and a visual aid with no independent analytical importance. In contrast to Hirshleifer’s deployment of the representative-individual, representative-agent in the DSGE model is used as an assumption whereby an analytical solution to the DSGE model can be derived, allowing the modeler to generate quantitative results to be compared with existing time-series data, to generate forecasts of future economic conditions, and to evaluate the effects of alternative policy rules.

The prominent and dubious role of the representative agent in DSGE models provided a convenient target for critics of DSGE models to direct their criticisms. In Congressional testimony, Robert Solow famously attacked DSGE models and used their reliance on the representative-agents to make them seem, well, simply ridiculous.

Most economists are willing to believe that most individual “agents” – consumers investors, borrowers, lenders, workers, employers – make their decisions so as to do the best that they can for themselves, given their possibilities and their information. Clearly they do not always behave in this rational way, and systematic deviations are well worth studying. But this is not a bad first approximation in many cases. The DSGE school populates its simplified economy – remember that all economics is about simplified economies just as biology is about simplified cells – with exactly one single combination worker-owner-consumer-everything-else who plans ahead carefully and lives forever. One important consequence of this “representative agent” assumption is that there are no conflicts of interest, no incompatible expectations, no deceptions.

This all-purpose decision-maker essentially runs the economy according to its own preferences. Not directly, of course: the economy has to operate through generally well-behaved markets and prices. Under pressure from skeptics and from the need to deal with actual data, DSGE modellers have worked hard to allow for various market frictions and imperfections like rigid prices and wages, asymmetries of information, time lags, and so on. This is all to the good. But the basic story always treats the whole economy as if it were like a person, trying consciously and rationally to do the best it can on behalf of the representative agent, given its circumstances. This cannot be an adequate description of a national economy, which is pretty conspicuously not pursuing a consistent goal. A thoughtful person, faced with the thought that economic policy was being pursued on this basis, might reasonably wonder what planet he or she is on.

An obvious example is that the DSGE story has no real room for unemployment of the kind we see most of the time, and especially now: unemployment that is pure waste. There are competent workers, willing to work at the prevailing wage or even a bit less, but the potential job is stymied by a market failure. The economy is unable to organize a win-win situation that is apparently there for the taking. This sort of outcome is incompatible with the notion that the economy is in rational pursuit of an intelligible goal. The only way that DSGE and related models can cope with unemployment is to make it somehow voluntary, a choice of current leisure or a desire to retain some kind of flexibility for the future or something like that. But this is exactly the sort of explanation that does not pass the smell test.

While Solow’s criticism of the representative agent was correct, he left himself open to an effective rejoinder by defenders of DSGE models who could point out that the representative agent was adopted by DSGE modelers not because it was an essential feature of the DSGE model but because it enabled DSGE modelers to simplify the task of analytically solving for an equilibrium solution. With enough time and computing power, however, DSGE modelers were able to write down models with a few heterogeneous agents (themselves representative of particular kinds of agents in the model) and then crank out an equilibrium solution for those models.

Unfortunately for Solow, V. V. Chari also testified at the same hearing, and he responded directly to Solow, denying that DSGE models necessarily entail the assumption of a representative agent and identifying numerous examples even in 2010 of DSGE models with heterogeneous agents.

What progress have we made in modern macro? State of the art models in, say, 1982, had a representative agent, no role for unemployment, no role for Financial factors, no sticky prices or sticky wages, no role for crises and no role for government. What do modern macroeconomic models look like? The models have all kinds of heterogeneity in behavior and decisions. This heterogeneity arises because people’s objectives dier, they differ by age, by information, by the history of their past experiences. Please look at the seminal work by Rao Aiyagari, Per Krusell and Tony Smith, Tim Kehoe and David Levine, Victor Rios Rull, Nobu Kiyotaki and John Moore. All of them . . . prominent macroeconomists at leading departments . . . much of their work is explicitly about models without representative agents. Any claim that modern macro is dominated by representative-agent models is wrong.

So on the narrow question of whether DSGE models are necessarily members of the representative-agent family, Solow was debunked by Chari. But debunking the claim that DSGE models must be representative-agent models doesn’t mean that DSGE models have the basic property that some of us at least seek in a macro-model: the capacity to explain how and why an economy may deviate from a potential full-employment time path.

Chari actually addressed the charge that DSGE models cannot explain lapses from full employment (to use Pigou’s rather anodyne terminology for depressions). Here is Chari’s response:

In terms of unemployment, the baseline model used in the analysis of labor markets in modern macroeconomics is the Mortensen-Pissarides model. The main point of this model is to focus on the dynamics of unemployment. It is specifically a model in which labor markets are beset with frictions.

Chari’s response was thus to treat lapses from full employment as “frictions.” To treat unemployment as the result of one or more frictions is to take a very narrow view of the potential causes of unemployment. The argument that Keynes made in the General Theory was that unemployment is a systemic failure of a market economy, which lacks an error-correction mechanism that is capable of returning the economy to a full-employment state, at least not within a reasonable period of time.

The basic approach of DSGE is to treat the solution of the model as an optimal solution of a problem. In the representative-agent version of a DSGE model, the optimal solution is optimal solution for a single agent, so optimality is already baked into the model. With heterogeneous agents, the solution of the model is a set of mutually consistent optimal plans, and optimality is baked into that heterogenous-agent DSGE model as well. Sophisticated heterogeneous-agent models can incorporate various frictions and constraints that cause the solution to deviate from a hypothetical frictionless, unconstrained first-best optimum.

The policy message emerging from this modeling approach is that unemployment is attributable to frictions and other distortions that don’t permit a first-best optimum that would be achieved automatically in their absence from being reached. The possibility that the optimal plans of individuals might be incompatible resulting in a systemic breakdown — that there could be a failure to coordinate — does not even come up for discussion.

One needn’t accept Keynes’s own theoretical explanation of unemployment to find the attribution of cyclical unemployment to frictions deeply problematic. But, as I have asserted in many previous posts (e.g., here and here) a modeling approach that excludes a priori any systemic explanation of cyclical unemployment, attributing instead all cyclical unemployment to frictions or inefficient constraints on market pricing, cannot be regarded as anything but an exercise in question begging.


My Paper “Hawtrey and Keynes” Is Now Available on SSRN

About five or six years ago, I was invited by Robert Dimand and Harald Hagemann to contribute an article on Hawtrey for The Elgar Companion to John Maynard Keynes, which they edited. I have now posted an early (2014) version of my article on SSRN.

Here is the abstract of my article on Hawtrey and Keynes

R. G. Hawtrey, like his younger contemporary J. M. Keynes, was a Cambridge graduate in mathematics, an Apostle, deeply influenced by the Cambridge philosopher G. E. Moore, attached, if only peripherally, to the Bloomsbury group, and largely an autodidact in economics. Both entered the British Civil Service shortly after graduation, publishing their first books on economics in 1913. Though eventually overshadowed by Keynes, Hawtrey, after publishing Currency and Credit in 1919, was in the front rank of monetary economists in the world and a major figure at the 1922 Genoa International Monetary Conference planning for a restoration of the international gold standard. This essay explores their relationship during the 1920s and 1930s, focusing on their interactions concerning the plans for restoring an international gold standard immediately after World War I, the 1925 decision to restore the convertibility of sterling at the prewar dollar parity, Hawtrey’s articulation of what became known as the Treasury view, Hawtrey’s commentary on Keynes’s Treatise on Money, including his exposition of the multiplier, Keynes’s questioning of Hawtrey after his testimony before the Macmillan Committee, their differences over the relative importance of the short-term and long-term rates of interest as instruments of monetary policy, Hawtrey’s disagreement with Keynes about the causes of the Great Depression, and finally the correspondence between Keynes and Hawtrey while Keynes was writing the General Theory, a correspondence that failed to resolve theoretical differences culminating in Hawtrey’s critical review of the General Theory and their 1937 exchange in the Economic Journal.

Mankiw’s Phillips-Curve Agonistes

The steady expansion of employment and reduction in unemployment since the recovery from the financial crisis of 2008 and the subsequent Little Depression, even as inflation remained almost continuously between 1.5 and 2% (with only a slight uptick to 3% in 2011), has led many observers to conclude that the negative correlation between inflation and unemployment posited by the Phillips Curve is no longer valid. So, almost a month ago, Greg Mankiw wrote New York Times Sunday Business Section defending the Phillips Curve as an analytical tool that ought to inform monetary policy-making by the Federal Reserve and other monetary authorities.

Mankiw starts with a brief potted history of the Phillips Curve.

The economist George Akerlof, a Nobel laureate and the husband of the former Federal Reserve chair Janet Yellen, once called the Phillips curve “probably the single most important macroeconomic relationship.” So it is worth recalling what the Phillips curve is, why it plays a central role in mainstream economics and why it has so many critics.

The story begins in 1958, when the economist A. W. Phillips published an article reporting an inverse relationship between unemployment and inflation in Britain. He reasoned that when unemployment is high, workers are easy to find, so employers hardly raise wages, if they do so at all.

But when unemployment is low, employers have trouble attracting workers, so they raise wages faster. Inflation in wages soon turns into inflation in the prices of goods and services.

Let’s pause for a moment and think about that explanation. If we translate it into a supply-demand framework in which the equilibrium corresponds to the intersection of a downward-sloping demand for labor curve with an upward-sloping supply of labor curve. The equilibrium is associated with some amount of unemployment inasmuch as there are always some workers transitioning from one job to another. The fewer and the more rapid the transitions, the less unemployment. The farther to the right the intersection of the demand curve and the supply curve, the more workers are employed and the fewer are transitioning between jobs in any time period.

I must note parenthetically that, as I have written recently, a supply-demand framework (aka partial equilibrium analysis) is not really the appropriate way to think about unemployment, because the equilibrium level of wages and the rates of unemployment must be analyzed, as, using different terminology, Keynes argued, in a general equilibrium, not a partial equilibrium, framework. But for ease of exposition, I use the partial equilibrium supply-demand paradigm.

Mankiw’s assertion that when unemployment is low, employers have trouble attracting workers, and therefore have to raise wages to hire, or retain, as many workers as they would like to employ, could be true. And that is the way that Mankiw wants us to focus on the relationship between wages and unemployment. Mankiw is focusing on the demand side as an explanation for low unemployment. But low unemployment could also reflect the eagerness of workers to be employed, even at low wages, so that workers quickly accept job offers rather than searching or holding out for better offers.

This is a classic issue in empirical estimates of demand. If high prices are associated with high output, does that mean that the data show that demand curves are upward-sloping, so that when suppliers raise price, customers increase want to buy more of their products? Obviously not. Suppliers raise their price because at low prices their customers are want to buy more than producers want to sell. So to estimate a demand curve, there must be some way of identifying factors that cause the entire demand curve to shift.

The identification problem in estimating demand curves has been understood since the early years of the 20th century. It is incredible that economists, especially one as steeped in the history of the discipline as Mankiw, talk about the Phillips Curve as if they had never heard of the identification problem.

When you estimate a demand curve without being able to identify shifts in demand, you are not estimating a demand curve, you are estimating a reduced form that combines — and fails to identify or distinguish between — both demand and supply. The Phillips Curve is a reduced form that captures both factors that affect the demand for labor and the supply of labor, though as I mentioned above, talking about the demand for labor and the supply of labor in the normal partial equilibrium sense of those terms is itself misleading and inappropriate.

What is unambiguously true, however, is that whatever else the Phillips Curve may be, it is a reduced form and not a deep structural relationship in an economy. It therefore is of little if any use in helping policy makers figure out whether to tighten or ease monetary policy.

For centuries, economists have understood that inflation is ultimately a monetary phenomenon. They noticed that when the world’s economies operated under a gold standard, gold discoveries resulted in higher prices for goods and services. And when central banks in economies with fiat money created large quantities — Germany in the interwar period, Zimbabwe in 2008, or Venezuela recently — the result was hyperinflation.

But economists also noticed that monetary conditions affect economic activity. Gold discoveries often lead to booming economies, and central banks easing monetary policy usually stimulate production and employment, at least for a while.

The Phillips curve helps explain how inflation and economic activity are related. At every moment, central bankers face a trade-off. They can stimulate production and employment at the cost of higher inflation. Or they can fight inflation at the cost of slower economic growth.

The Phillips curve, a reduced form, a mere correlation revealing no deep or necessary structural relationship between inflation and unemployment, explains nothing. It merely reflects the fact that, under a certain set of conditions, monetary expansion is associated with increased output and employment, and, accordingly, with reduced unemployment. And, under a certain set of conditions, monetary contraction is associated with reduced output and unemployment, and, accordingly, increased unemployment. We know now – and have long known — all about those relationships, without the Phillips Curve.

But under other conditions, high inflation may be associated with non-monetary factors (negative supply shocks) causing falling output and employment. And under still other conditions, low inflation may be associated with rising output and employment. There is no deep structural reason causing low unemployment to be incompatible with low inflation or causing high unemployment to be incompatible with high inflation. To suggest that the Phillips Curve is somehow a necessary relationship rather than a coincidental correlation between inflation and unemployment is a shockingly superficial reading of the evidence betraying an embarrassing misunderstanding of elementary theory.

Mankiw seems to be vaguely aware of his own confusion when he writes the following.

Today, most economists believe there is a trade-off between inflation and unemployment in the sense that actions taken by a central bank push these variables in opposite directions.

Mankiw’s qualification that the trade-off between inflation and unemployment reflects the tendency of rapid monetary expansion to cause output and employment to expand (at least temporarily) and prices to rise is a tacit admission that there is no necessary trade-off between inflation and unemployment. What we refer to as a Phillips Curve is simply the tendency for changes in monetary policy to affect inflation and unemployment in opposite directions, not a necessary structural relationship between inflation and unemployment. This is not rocket science. I can’t understand why Mankiw has trouble understanding that the fact that monetary policy may cause unemployment to rise when it causes inflation to fall and vice versa seems is not the same thing as a necessary inverse relationship between inflation and unemployment.

As a corollary, they also believe there must be a minimum level of unemployment that the economy can sustain without inflation rising too high. But for various reasons, that level fluctuates and is difficult to determine.

The level of unemployment that can be sustained without inflation is both unobservable and subject to change. Monetary policy can stimulate a rapid reduction in unemployment when unemployment is clearly higher than normal, as unemployment falls ongoing monetary expansion carries a risk of increasing inflation. But that doesn’t mean that unemployment cannot continue to fall without triggering an increase in inflation.

Mankiw concludes with the following bit of advice.

The Fed’s job is to balance the competing risks of rising unemployment and rising inflation. Striking just the right balance is never easy. The first step, however, is to recognize that the Phillips curve is always out there lurking.

That is just silly. The risk of increasing inflation is there with or without recognizing that the Phillips curve is out there lurking. To avoid the risk of inflation in a responsible way means using monetary policy to keep the rate of increase in nominal GDP within a reasonably narrow band providing enough room for the normal rate of growth in output with a rate of inflation sufficient to keep nominal interest rates moderately low, but substantially above zero. You don’t need a Phillips curve to figure that out.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.


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