Saturday, February 22, 2014

They think it doesn't work, but they use it anyway.

The other day I wrote:

I assume Sethi, like everybody else, bases his determination on economic conditions. You know, the Phillips tradeoff: inflation and unemployment. The great, sad irony is that we continue to rely on the Phillips tradeoff, even though the Phillips curve has had the obligatory funeral.

I was a little nervous about that. Not because I said Sethi relies on the Phillips tradeoff, no. That's a specific statement, easily corrected if I got it wrong. I was nervous about the general statement, my claim that everybody relies on the Phillips tradeoff. I'm nervous because the statement is based on my impression of things. I like to have something stronger behind what I say.

So I was glad to read JW Mason write:

... Perhaps more importantly, this is a rejection not just as of MMT but of almost all policy-oriented macroeconomics, mainstream and heterodox. Whether you're reading David Romer or Wendy Carlin or Lance Taylor, you're going to find a Phillips curve that relates inflation to current output.

In other words, in almost all policy-oriented macro, you find the Phillips relation. Wow, was I happy to read that!

Mason again:

MMT has exactly the same theory of inflation as orthodox macro: High or rising inflation is the result of output above potential, disinflation or deflation the result of output below potential. In other words, MMT is consistent with a standard Phillips curve of the same kind Palley (and almost everybody else) uses.

Romer and Carlin and Taylor and MMT and Palley and almost everybody else: They all rely on the Phillips curve.

So I feel a little better about my impression of things.

From Mark Thoma
Like Robert Waldmann, I have always taught that the Phillips curve was initially promoted as a permanent tradeoff between inflation and unemployment. It was thought to be a menu of choices that allowed most any unemployment rate to be achieved so long as we were willing to accept the required inflation rate...

However, the story goes, Milton Friedman argued this was incorrect in his 1968 presidential address to the AEA. Estimates of the Phillips curve that produced stable looking relationships were based upon data from time periods when inflation expectations were stable and unchanging. Friedman warned that if policymakers tried to exploit this relationship and inflation expectations changed, the Phillips curve would shift in a way that would give policymakers the inflation they were after, but the unemployment rate would be unchanged. There would be costs (higher inflation), but not benefits (lower unemployment).

When subsequent data appeared to validate Friedman's prediction, the New Classical, rational expectations, microfoundations view of the world began to gain credibility over the old Keynesian model...

That was the beginning of the end of the Keynesian consensus.

It was also the end of the Phillips Curve. Except, it wasn't. The Curve got split in two: the short run, and the long run. Like wise men, everybody rejected the long version. But everybody still relies on the short version. In other words: They think it doesn't work, but they use it anyway.

Here -- The CBO relies on the Phillips tradeoff when they figure Potential output:

CBO’s estimate of potential output is based on ... a relationship known as Okun’s law.

According to that relationship, actual output exceeds its potential level when the rate of unemployment is below the “natural” rate of unemployment...

For the natural rate of unemployment, CBO uses... NAIRU [which] derives from an estimated relationship known as a Phillips curve...

Everything seems to depend on the difference between short-run and long-run. So I ask: What happens in those precious moments between the short run and the long?

In the short run, they increase the money rapidly, catching us by surprise, and so we buy more and produce more because we have more money without knowing it, and unemployment goes down. That's the short run.

In the long run we figure it all out, and we swear we won't get fooled again. We quit buying more and we quit producing more because we know about the money now. And unemployment goes back up.

Is that really what Milton Friedman said?

1 comment:

Tom Hickey said...

You will find the MMT position put forward by Bill Mitchell in the draft of the MMT textbook at the following links in the fourteen parts of the section on Unemployment and Inflation, including discussion of the Phillips curve, which Bill is an expert. He started working on it in his PhD dissertation. This is for an intro macro book so it is not complicated.