Friedman's Presidential Address after 50 years

At the recent AEA meetings in Philadelphia, there was a panel discussing Friedman’s famous AEA presidential address, which occurred 50 years ago. Thus I decided to reread this famous article.

It’s just as impressive as I remember. Although just 17 pages and containing no equations, it is perhaps the best macroeconomics article ever published—written by the world’s greatest macroeconomist when he was at the peak of his game.

Here’s something that caught my eye, where Friedman is discussing the effect of a monetary expansion that boosts nominal spending:

To begin with, much or most of the rise in income will take the form of an increase in output and employment rather than in prices. People have been expecting prices to be stable, and prices and wages have been set for some time in the future on that basis. It takes time for people to adjust to a new state of demand. Producers will tend to react to the initial expansion in aggregate demand by increasing output, employees by working longer hours, and the unemployed, by taking jobs now offered at former nominal wages. This much is pretty standard doctrine.

But it describes only the initial effects. Because selling prices of products typically respond to an unanticipated rise in nominal demand faster than prices of factors of production, real wages received have gone down-though real wages anticipated by employees went up, since employees implicitly evaluated the wages offered at the earlier price level. Indeed, the simultaneous fall ex post in real wages to employers and rise ex ante in real wages to employees is what enabled employment to increase. But the decline ex post in real wages will soon come to affect anticipations. Employees will start to reckon on rising prices of the things they buy and to demand higher nominal wages for the future. “Market” unemployment is below the “natural” level. There is an excess demand for labor so real wages will tend to rise toward their initial level.

There are two ways to visualize causation in the Phillips Curve relationship. The standard view (NAIRU) seems to be that low unemployment causes rising inflation. I’ve always assumed that Friedman saw causation in the opposite direction (as do I.) Unexpectedly high inflation (usually this means rising inflation) causes low unemployment.

Interestingly, the two paragraphs quoted above seem to support both interpretations. In the first paragraph, output and employment respond before prices. That makes it seem like the eventual response of prices is caused by output gaps.

In the second paragraph, however, Friedman emphasizes that prices respond more quickly than wages. It is the rise in prices following monetary stimulus that reduces real wages, because nominal wages are assumed to be even stickier than prices. Indeed the fall in real wages caused by unexpected inflation can be seen as having “enabled” the rise in employment. That’s also my view.

[As an aside, some have argued that studies of real wage cyclicality are inconsistent with sticky wage models of the business cycle. In 1989, Steve Silver and I published an article in the JPE that showed why this is not true. Observed real wage cyclicality is fully consistent with the sticky wage model of the business cycle, which was the standard (pre-Keynesian) model of the interwar era.]

So which is it? Do output gaps cause inflation, or does inflation cause output gaps? As Janet Yellen has recently discovered, the first interpretation is not particularly useful as a forecasting technique. And not just in 2017, the NAIRU model has had trouble forecasting under a wide range of circumstances.

On the other hand, price stickiness does exist, and thus there are real problems with simply viewing causality going from unexpected inflation to output. Obviously, if I claim that “a Fed policy of suddenly driving the economy into severe deflation would cause mass unemployment”, most people know what I mean. But inflation/deflation is probably not the best way of visualizing this process, a point that George Selgin often emphasizes.

Once we replace inflation with NGDP growth, these conundrums all go away. And I find that fact to be pretty interesting, as NGDP targeting is now widely seen as a plausible alternative to inflation targeting. Thus when discussing monetary policy, inflation and NGDP growth are simply viewed as two alternative nominal aggregates. Pick one.

But if I switch over to the Phillips Curve model, and tell economists that we should replace inflation with NGDP growth, they often seem kind of puzzled. Thus I argue that unexpected NGDP growth drives the unemployment rate lower, and unexpectedly low NGDP growth raises unemployment. It’s not that they disagree; rather they don’t see the point I am making.

Most economists view NGDP growth as a sort of centaur, half man/half beast. They see it as the sum of inflation and real growth. So if you start with a model where real growth causes inflation, then how in the world are we to think about a model where (growth in) the causal variable (NGDP) is the sum of those two primary macroeconomic aggregates—P & Y?

The same economists who can’t imagine how high inflation could cause low unemployment, have no trouble visualizing how high NGDP could cause low unemployment. But they don’t see NGDP as the sort of variable we should be talking about. Indeed my claim almost seems like a tautology to some people, even though the case of Zimbabwe 2008 shows that it’s anything but a tautology.

I have another post on this paper over at TheMoneyIllusion.

P.S. There were also centauresses? Who knew?