American Economic Association

American Economic Association
Unemployment, Inflation, and Monetarism Author(s): Jerome L. Stein Reviewed work(s): Source: The American Economic Review, Vol. 64, No. 6 (Dec., 1974), pp. 867-887 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/1815239 . Accessed: 11/12/2012 06:49
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Unemployment, Inflation, and

By
Edmund Phelps of the Council of the grounds that model of the U.S. policies that were inflation.
Monetarism
JEROME
L.
STEIN*
criticized the game plan Economic Advisers on they had no explicit economy to justify the undertaken to curb the
The Council's Report provides a look at the 1969-71 game plan to disinflate by means of retarding aggregate demand.... The President-Elect's Task Force on Inflation recommended, as a first interim step, that aggregate demand be slowed so as to bring the unemployment rate back to some equilibrium region around 4.5 percent.... What happened was that, under the cover of the expectation and acceptance of such a limited step towards re-equilibration, the Administration gradually tightened monetary and fiscal policy so severely as 'gradually' to send the unemployment rate whizzing past the equilibrium zone to around 6 percent. To my knowledge the theory of how, and how well, this medicine would act to cure the patient of his inflation was never spelled out by the Council of Eco-
nomic Advisers.[pp. 533--34]
Since the Council had no explicit model of the U.S. economy, they could neither explain the paradox of unemployment cum inflation nor could they evaluate the probable effects of alternate economic policies. The econometrics of wage and price determination have been actively studied in receint years. Important articles on this
* Brown University. I am indebted to W. Bomberger, G. H. Borts, M. Friedman, J. Frenkel, H. Hori, E. F. Infante, N. Liviatan, and J. P. LaSalle for their perceptive criticisms of an earlier draft. The John Simon Guggenheim Foundation provided financial assistance for this study, which was written while I was at the Hebrew University in Jerusalem. 867
subject appear in the Brookings Papers on Economic Activity and in the Proceedings of the Federal Reserve-Social Science Research Council (SSRC) Conference (edited by Otto Eckstein, papers by Hymans, Klein, de Menil and Enzler, Hirsch, Bodkin, Ball and Duffy, Eckstein and Wyss, Heien and Popkin, and Andersen and Carlson, among others). The Proceedings were analyzed by James Tobin in his summary comments. These studies generally contain three equations: a wage change equation, a price change equation, and an equation describing the formation of price expectations. The unemployment rate is taken as an exogenous variable; and the models do not explicitly contain monetary and fiscal policy variables.' Therefore, they cannot explain (i) the simultaneous determination of, and interactions between, the unemployment and inflation rates and (ii) the effects of monetary and fiscal policies upon the paths of the unemployment and inflation rates. The Andersen and Carlson study is an exception, however; it does contain the unemployment rate as an endogenous variable as well as the monetary and fiscal policy variables. It can and has been used to simulate the effects of policy. However, that model cannot be solved analytically; and its theoretical foundations are neither clear nor widely accepted.2
1 Tobin summarized the FRB-SSRC models in this way: "These four equations form a subsystem of a complete model that given an initial price history is capable of determining prices, price expectations, and wages. Unemployment, past and present, and rental cost of capital can be taken as exogenous to the subsystem" (1972a, p. 6). 2 Two studies of the relation between unemployment
868
THE AMERICAN ECONOMIC REVIEW
DECEMBER 1974
Paul Samuelson wrote that "The central issue that is debated these days in connection with macro-economics is the doctrine of monetarism" (p. 7). However, there is no satisfactory theory of monetarism. Milton Friedman's attempt to provide a theoretical explanation of the monetarist position has been deemed unsuccessful both by neo-Keynesians and by other leading monetarists. Tobin described Friedman's theoretical framework as follows: He undoubtedly hoped that the use of a common theoretical apparatus would reduce the controversy about the roles of monetary and fiscal policies to an econometric debate about empirical magnitudes. If the monetarists and the neo-Keynesians could agree as to which values of which parameters in which behavior relations imply which policy conclusions, then they could concentrate on the evidence regarding the values of those parameters. I wish that these articles had brought us closer to this goal, but I am afraid they have not. [1972c, pp. 852-53] According to Karl Brunner, who is a leading exponent of monetarism: Monetarist ideas have become almost respectable in recent years and the central propositions about the role of money and monetary policy have been increasinglv accepted or at least seriously pondered. Still, the monetarist position remains an unsettled issue with respect to both its degree of confirmation and its analytic formulation. [p. 2] Brunner and Allan Meltzer agree with Tobin's criticism of Friedman's article on monetarism: "We regard Friedman's discussion as either misleading or a complete reversal of his often stated position" (p. 846). My paper attempts to explain the phenomena of unemployment cum inflation and the analytic foundations of the moneand inflation must also be mentioned: David Laidler and the paper by the author and Ettore Infante.
tarist position within the context of a single model. In Section I, I develop a simple smallscale dynamic model of the economy, whose salient features are accepted by most macro-economic theorists. The state variables are denoted by X, and it is the vector containing the unemployment rate, the rate of price change, and the expected rate of price change. Control variables denoted by vector C are the monetary and fiscal policies followed by the government. The dynamic model described by DX= AX+ BC, D _ dldt
is easily solved analytically because it only contains three linear differential equations with constant coefficients. Every equation can be understood very easily, and the dynamics of the system and effects of policies can be clearly traced. Its steady-state and dynamic properties are discussed in Section II. Section III explains the phenomenon of unemployment cum inflation, and Section IV explains the logical foundations of monetarism, on the basis of the model contained in Sections I and II. A simple phase diagram is used as a graphic device to explain the qualitative implications of the dynamical system. Quantitative accuracy can only be obtained by estimating the coefficients of the dynamic model. Preliminary work along this line is encouraging, but is not reported here. My exclusive concentration in this paper is upon the theory. I. A Simple Dynamic Model of the Macroeconomy In the short run, the ratio of effective labor supplied per unit of capital is assumed to be relatively constant; and the state variables are the unemployment rate (U), the rate of price change (ir), and the expected rate of price change (wx*). This section develops the complete model applicable to an economy where the ratio
VOL. 64 NO. 6
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869
of effective labor supplied per unit of capital is also a state variable. In the subsequent parts, only the short-run version will be used. A. The Labor Market and the Unemployment Equation The Walrasian labor market adjustment equation (1) states that the rate at which nominal wage W changes is a linear combination of two elements: the expected rate of price change ir*, and the state of the labor market.
Uf
\Ut
0)
Xd-x
DW
DW~ ~~X *XI2(Va
lNd
- N )
> 0
FIGURE 1. THE UNEMPLOYMENT RATE IS NEGATIVELY RELATED TO THE EXCESS DEMAND FOR LABOR
No dichotomy is made between expectations of employers and of employees in this single sector macro-economic model; hence 7r* reflects both the expected change in the price of output and the expected change in the price of goods purchased by consumers. The state of the labor market is reflected by the second term X1(.). Variables Nd and Ns refer to the quantities of labor services demanded and supplied, respectively. Function X' is positive; the growth of the nominal wage DW/W is positively related to the excess demand forlabor(Nd-N,)/N, for the usual reasons. If the state of the labor market is given, variations in the expected rate of price change by employers and employees lead immediately to corresponding changes in the growth of the nominal wage. Assume that technical change is Harrodneutral, so that "effective labor" is a multiple A (t) of labor in natural units. Then equation (1) can be written as (2) where Xd and x, refer to effective labor per unit of capital demanded and supplied, respectively. Ratio Nd/N, = Xd/X, when technical change is labor-augmenting. (2) DW
The excess demand for labor is not directly observable, though the closest direct measure of it may be the number of vacancies less the number of people unemployed. Equation (3) states that the measured unemployment rate U is negatively related to the excess demand for labor; and it is described in Figure 1. This assumption permits both positive and negative excess demands for labor to be associated with a positive unemployment rate. It does not require that we assume that the quantity of labor employed is the smaller of the quantity demanded or supplied. At full employment (see Figure 1), the unemployment Uf Ns is equal to vacancies. Equation (3) is sufficiently general to be consistent with a wide range of microeconomic theories of labor markets. The inverse function is described by equation (4). (3) H
/Xd Xs\
H' < 0; (4) H-1(U) =

__
Xs
1_ U _ 0
(HK1)'< 0
= 7r* +
(Xd
-Xs)
x8
The actual ratio of effective labor em-
870
DECEMBER 1974
ployed per unit of capital, denoted by x (without a subscript), is equation (5) below.3
(5)
x-(1
- U)x"
If equation (4) is substituted into (2), then the frequently used wage change equation (6) is derived. Function h is the composition of X1and H-1, i.e., h-=1 o H-1, and h' is negative. Equation (7) is a linearization of (6). (6) DW -
7r*+h(U),
h' < O
(7)
DW =
7r* +
ho- hlU
The excess demand for labor per unit of capital (equation (8) below) requires some explanation. The demand for labor arises from the private and the government sectors. In the private sector, the quantity of labor demanded per unit of capital depends upon the real wage w adjusted for the level of technology A(t). Specifically, the quantity of labor demanded by the private sector per unit of capital depends upon w/A (t). Some of the output will be purchased by the private sector and some will be purchased by the government. The government also purchases the services of labor directly: the real gross product originating in the government sector is the real value of the compensation of employees. It is identically equal to a fixed multiple of the labor input of government employees, because gross product in constant prices per man-hour in the government sector is defined (by the Department
3The implication of (3) and (5) is that the ratio of employment to the quantity demanded N/Nd = X/Xd is
I
of Commerce) to be unchanging over time. The government is not a profit maximizer in the conventional sense. Its direct demand for labor services per unit of capital G, can be taken as a control variable differing in magnitude from its purchases of goods from the private sector. Assume for simplicity that GCis a fraction t of total real government purchases of goods and services per unit of capital G; i.e., G1= G. In general, t will not be a constant, and both t and G will constitute control variables. Therefore, the quantity of labor demanded per unit of capital4 depends upon w/A (t) and {G, and is xd= F(w/A (t), G). The supply of effective labor per unit of capital x, is assumed to be inelastic with respect to the real wage, and in the "short run," ratio x, is assumed to be relatively constant. Therefore, the excess demand for labor per unit of capital, resulting from the activities of the private sector, is related to w/A(t) the adjusted real wage. Combining the private and government sectors equation (8) is derived.
Xd -
(8)
=1
X,
(j
, G;
x
2>
f2 >
?
fl < O,
i<,
Substitute equation (4) into (8) and derive equation (9). This shows the dependence of the unemployment rate U on the adjusted real wage w/A (t) and on the real value of government purchases of goods
4Let xl be the quantity of labor demanded per unit of capital in the private sector which produces goods purchased by both the private sector and the government. Then w/A (t) = F*(x') or xl = F(w/A (t)), where F is the inverse of F*, is the labor demand function. The government, which is not a profit maximizer in the usual sense, demands x" of labor per unit of capital in the economy. Then Xd=X+X,' = F(w/A (t))+x1'. Since GI is defined as xl', then Xd = F(w/A (t)) + G1. It is assumed that all of the capital is in the sector producing goods. If G1= {G, where G is the total demand by the government for goods and services per unit of capital, then, Xd = F (wlA (t)) + FG.
(-
_I Xs
x
Xd
Xd/X,
At any instant of time, firms are not necessarily on their demand curves for labor nor are households necessarily on their supply curves.
VOL. 64 NO. 6
*
w
STEIN: MONETARISM
871
A (t)
G G1
U~~~~ w2
WO
B
Ut
A
Ue
> 0 and DA /A = a. Substitute (6) into (10), since DW/W-7r = Dw/w, and derive differential equation (11) for the change in the unemployment rate. If the linear form of the wage change equation (7) were used, then differential equation (12) would be derived.
+ (11) DU = ,01(7r* h(U) -7r

= -lh(U) -
a)-
,2DG
01w +
ilr*
h(U)
a41- ,2DG
(12) DU=
1(7r*+1hoh1iU - ,2DG
U-lr
-
- r-a)
*
= (-3lhl)
+ 017+
+ Oi(ho - a)
DW_ '
FIGURE 2. THE DETERMINATION OF THE EQUILIBRIUM UNEMPLOYMENT RATE Ue AND ADJUSTED REAL WAGE W*
,2DG
and services per unit of capital.5

/w \
Y
These formulations imply Friedman's "natural" (equilibrium) rate of unemployment Ue because the coefficient of 7r* in equation (1) is unity. When the actual rate of price change is fully anticipated, and both U and G are constant, then (12) implies (13). (13)
Ue
=
(ho -
a)jhl
(9j
H-1(U) =f t(
G)
This basic equation is illustrated in the top half of Figure 2. The unemployment rate is positively related to the trend adjusted real wage w/A(t), and negatively related to the government's direct demand for labor services. Differentiate equation (9) with respect to time and derive equation (10). Although the coefficients ,1 and O2 are functions of time, I treat them as relatively constant values in order to work with a time invariant linear system. Coefficient ,1 is an elasticity. (10) DU=
Dw\
K w
a)-
2DG (H-1) '
' where,B1=-f1(H-1)wlA > 0; 02=--f2/-
I Since x, is considered to be relatively constant, it will not be written explicitly in the f( ) function.
Equations (12) and (13) are macroeconomic relations which reflect the distribution of employment and unemployment among various sectors, each of which may have a different relation between the unemployment rate and the corresponding rate of nominal wage change. The dispersion of the unemployment may be reflected by ho and h1, and the equilibrium rate of price change may affect the dispersion of unemployment and employment. Therefore, the equilibrium rate of price change may affect the equilibrium unemployment rate via vector (ho, hi, a) even though the coefficient of 7r in equation (1) is unity. It would be surprising if the macro-economic equilibrium rate of unemployment Ue were constant over a decade, since the distribution of employment and unemployment are unlikely to be constant. This is an empirical question to be examined. In-
872
DECEMBER 1974
telligent economic policy must take into account the likelihood that (ho, h,, ca) may not be constant over time, and may even be related to the equilibrium rate of price change.6 Define x1- U- Ue, the deviation of the unemployment rate from the equilibrium rate Ue. Then Dxl=DU. Substitute (13) into (12) and derive equation (14), the differential equation for the unemployment rate. (14)
Dxi =_
lhl
xl -7r
+ Olr* -
DG
This equation states that the change in the deviation x1 between the actual and the equilibrium unemployment rate is negatively related to the deviation xi, negatively related to unanticipated inflation (7r-7r*), and negatively related to the change in real purchases of goods and services by the government. Variable DG is a control variable, variables 7r and 7r* are state variables which I shall now discuss. B. Price Change Equations A virtue of the widely used adaptive expectations equation (15) is that expectations are allowed to change slowly but smoothly in light of past experience. If the reader were asked to predict the rate of inflation over the coming year, the expected rate of monetary expansion would be an important variable in determining his forecast; and he would not confine his attention to a weighted average of past rates of price change. Further work must be directed to replacing this equation with something better.7 In the interim, I use (15) to reflect expectations which may be changing slowly.
(15) Dir* = b(r
-
where (wr--*) is unanticipated inflation or deflation.8 The actual rate of price change r is the resultant of excess demand and cost pressures. If there were no excess demand for goods and services, the rate of price change would equal the growth of the nominal wage DW/IW less the trend rate of technical progress a. There seems to be a consensus that this is a measure of cost pressure.9 If (DW/W-a) were zero, then the rate of price change would be proportional to E, the excess demand for goods per unit of capital. Coefficient X, is a finite speed of response.10 (16)
r =
DW/W-a
+XpE
My discussion of the determinants of the excess demand for goods per unit of capital
8 There are two extreme cases of equation (15). In (a), the expected rate of price change is equal to the current rate; in effect b is infinite. (a)
7r* =7X
Alternatively, b is zero, and the expected rate of price change is equal to the long-run steady-state value 7r,. We know that 7re is equal to the rate of monetary expansion , less the long-run growth of effective labor n. (b)
W*=7re =,U-n
9 The price change equation used in much of the recent econometric literature (see Tobin (1972a)) is:
DW
7r
= a12
W w
- aI3a + aI47r* + f(U
Ue)
*)
where U, is the average or normal unemployment rate. In these empirical studies the unemployment rate is taken as exogenous. The main findings are that a12a13= 1, and a modest effect of demand pressure is estimated, where U- U is negatively related to demand pressure. 10 I could have used the price change equation which characterized the "synthesis" model of money and growth (see the author, ch. 5): 7r= 7r*-+X,E where 7* is the expected rate of price change. The rationale behind this equation is that specialists change prices on the basis of expectations 7r*and market conditions E. Equation (16) in the text above implies that
lr = r* +J (U) -a + XE = 7r* + (E, U,a)
6 This issue has been discussed by Tobin (1972a, b) and in the Brookings Papers in connection with the subject: Has the Phillips curve shifted? 7See Tobin (1972a) and the author, pp. 64-66.
which is formally similar to the price change equation in the synthesis model. See the author and Infante, pp. 539-41.
VOL. 64 NO. 6
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873
will be terse, since it is largely based upon my 1971 study.
(18)
demand price of capital
C=qr
|
supply price R(t) P*(t) P(0)

-~~~e-Ptdt
C. The Excess Demand for Goods

The excess demand for goods per unit of capital E is equal to planned investment per unit of capital I/K plus planned consumption per unit of capital C/K plus real government purchases per unit of capital G less output per unit of capital Y/K. Define planned savings as output less planned consumption. It follows that
(1~~'
E =-
K+
K
Assume that: (i) the price of output is expected to change at proportionate rate 7r* such that P*(t) = P(O)e-*t, and (ii) the marginal physical product of capital R(t) = re-It, where r is the current marginal physical product of capital. Equation (18) can be written as (19) when the denominator is positive; i.e., when the nominal rate of interest p exceeds the expected appreciation 7r*- 3 of the asset.
is the real excess demand for goods per unit of capital." Investment decisions are made by firms, and are independent of the savings decisions of households. The following model of the investment process was derived from Keynes' analysis in the Treatise, I, pp. 200-09. The desired change in the ratio of capital to output is positively related to the demand price of capital relative to its supply price. The supply price is just the price of a unit of current output P(0). The demand price (capital value) is equal to the present value of the expected rents. Therefore, the desired change in the ratio of capital to output is positively related to the ratio of the present value of quasi rents to the price of a unit of current output. Let R(t) be the expected marginal physical product of the unit of capital at time t; P*(t) the expected price of output at time t; P(0) the current price of output; 5 the depreciation rate; and p the expected constant nominal rate of interest equal to the current rate. Then the ratio of the demand price of capital to its supply price is given by (18).
11 Alternatively, define E as the excess demand for capital: KD+C+G-(Ko+Y) where KD is the stock desired and KOis the existing stock. Since KD-Ko=I, the formulations are equivalent.
(19) q = rf
exp [-(p + 6
r
r*)t]dt
p+6
The desired change in the capital-output ratio is assumed to be positively related to (q- 1), the gap between the demand price of capital and its supply price. When q>1 or r+7r*-5>p, then firms wish to raise the ratio of capital to output. When q<1 or r+7r*-5<p, they wish to lower the ratio of capital to output. When the demand price of capital is equal to the supply price, q= 1 or then firms wish to maintain r+7r*-5=p, the existing ratio of capital to output. Suppose that effective labor were growing at proportionate rate n, and firms (correctly) expect output to grow at this rate in the long run. Then the desired growth of capital I/K is given by equation (20). This is the investment function.
(20) IIK =
n+ g(r 7r* -P)+a + -
Investment function (20) consists of two parts: The first term refers to the equilibrium desired growth of capital, and the second term refers to the adjustment of the capital-output ratio to the desired
874
DECEMBER 1974
proportion. Speed of response g is assumed to be finite.12 Output per unit of capital y depends upon the ratio of effective labor per unit of capital x, as described by equation (21).
ital is Om, where m- M/pK. Open-market equations affect 0 and hence it may be considered a control variable. The consumption function, described by (25), depends upon y and Om. (25) C/K = C(y, m, 0);
1
> C1 > O, C2 > 0, C3 >
0
(21)
y = y(x);
y' > O, y" < O
The production function is assumed to have the standard properties. The marginal product of capital r is derived from (21) in the usual manner. (22) r = r(x); r' > 0
Substitute equation (5) into these equations and derive equations (23) and (24), where output per unit of capital and the marginal product of capital depend upon the unemployment rate, given x,. (23) (24) y = y[(1 - U)x8] = Y(U); r = r[(1 - U)x,] = R(U); Y' < 0 R' < 0
A rise in the unemployment rate lowers x= (1 - U) xs and thereby reduces the marginal product of capital. Physical capital is assumed to be fully employed at all times, as a result of a perfectly flexible rental price. Savings are defined as output less planned consumption. The latter is a function, homogeneous of degree one, in capital, output, and real financial wealth. Usually, private financial wealth is assumed to be currency plus some fraction of the value of government interest bearing debt. Define 0 as the ratio of private financial wealth to the money supply (M). Then real financial wealth per unit of capIt is interesting to note that along an optimal growth path, the equation for Dk=D(K/N), where capital is K and effective labor is N, is given by
12
Fiscal policy in the form of a change in taxes less transfer payments is assumed to affect consumption insofar as it operates upon private wealth. This approach is based upon the assumption that consumption depends upon wealth rather than upon disposable income, and it obviates the need to build a tax rate schedule into the model. Implicit in this analysis is the government budget constraint. Taxes less transfers, plus changes in the federal interest-bearing plus non-interest-bearing debt are identically equal to the value of goods and services purchased by the government. The savings function is therefore defined by equation (26). Substitute (5) into (26) and derive (27). (26) S/K =y-C(y, (27) S/K=S[Y(U; m, 0) xs), m, 01
=S(y, m, 0); 1 >S1>O, S2<O, S3<O
Using (20) and (27), the excess demand for goods equation (17) can be written as equation (28). The excess demand for goods per unit of capital is a function of U, 7r, m, p and of G, x, and n. (28) E=I + -+ K K C
-
G--
Y K + 6
= n + g[R(U; xs) + wr*--p] S[Y(U; xs), m, 0] + G
Dk
A11 (k) f"'(k)
[f'(k)
(X+)]
where f(k) is output per unit of effective labor, X is the sum of the growth rate of effective labor and the depreciation rate, a is the social discount rate, A (k) is positive and f"(k) is negative. See Infante and the author.
The real net stock excess demand for bonds per unit of capital by the private sector depends upon: (i) the expected yield on capital r+wx*; (ii) the nominal rate of
VOL. 64 NO. 6
STEIN: MONETARISM
875 p = g(U, 7r*, m, 0);

gl < O, g2 > O, g3 < 0, g4 > 0
interest p; and (iii) real balances per unit of capital m. The first variable is an opportunity cost for owners of wealth, so that the excess demanded is negatively related to R(U)+7r*. For the usual reasons, the net excess demand for bonds by the private sector is positively related to the nominal rate of interest p. Real balances and real bonds are complementary assets in portfolios, so that the quantity of real bonds demanded per unit of capital should be positively related to real balances per unit of capital. Moreover, the quantity of real bonds supplied per unit of capital should be negatively related to the stocks of real balances per unit of capital held by firms. The real private excess demand for bonds per unit of capital can be written as B(R(U)+7r*, p, m), where B1<0, B2>0, B3>0. Let z be the real stock of government interest-bearing debt per unit of capital. Then equilibrium in the bond market implies that: (29) B(R(U) + lr*, p, m) = z
(31)
Substitute (31) into (28) and derive equation (32) for the excess demand for goods per unit of capital when the bond market is in equilibrium. (32) E = E(U,
7r*, m,
G, 6; x.)
Function E does not contain p, the nominal rate of interest, as an argument. The sign of aE/lO is the subject of controversy. A rise in 0, given m, will shift the LM curve upwards and raise the nominal rate of interest. Private investment will thereby be inhibited. On the other hand, the rise in 0 may raise consumption demand (via equation (26)), and thereby shift the IS curve upwards. The net effect of a rise in 0 upon E is not obvious on a priori grounds; and it is at the heart of the monetarist controversy. D. The Differential Equation for the Rate of Price Change The actual rate of price change is derived by substituting (32) and (7) into (16), and equation (33) is obtained. (33) X = *.+ ho-h U- a + XpE(U, 7r*,m, G, 6; x,) = P(U, 7r*,m, G, 0; x;) where O7w/OU= Pi=h+XPE, o7r/(97r*=P2= 1+XPE2 m(3r/dim) = P3 = mXpE3 cw/oG= P4= XpE4 Ow /06= P5= XPE5 Note that the unemployment rate U, and the expected rate of price change 7r*, affect both the costs of producing output and the excess demand for goods per unit of capital. This equation differs from the price adjustment equations commonly used in empirical work primarily because
Equation (30) describes the nominal rate of interest which equilibrates the bond market, and the partial derivatives have the usual signs.
(30) p = p(U, Ur,
mn,z)
where pi= -B1R'jB2<0, P2=-B1jB2>0; p3==-B3/B2<0; p4=1/B2>0. Since z is positively related to Om (real private wealth per unit of capital), the interest rate equation can also be written as (31) where gi and pi have the same signs. The important point is that, given m, a rise in 0 (or z) raises the nominal rate of interest by shifting the traditional LM curve upwards. Walras' law for stocks implies that, since the bond market is in equilibrium, the excess demand for real balances is equal to the excess supply of real capital.
876
DECEMBER 1974
state variable m and control variables G and 0 explicitly appear. Note also that P3 is an elasticity, for a reason that will be apparent shortly. The proportionate rate of change of real balances per unit of capital is given by equation (34). (34) Dm m = _ DK K
The construction of the dynamical system, where the ratio of effective labor per unit of capital is relatively constant, is now complete. The model contains three differential equations in three state variables: U, wr,and -x*. The long-run system is obtained by relaxing the assumption that x, is relatively constant.13 II. The Short-Run Dynamical System and its Equilibrium Properties There are three state variables in the above short-run macro-economic model: the deviation x= U- Ue of the unemployment rate from its equilibrium level; the rate of price change 7r; and the expected rate of price change 7r*. Control variables are: the change in real government purchases of goods and services14 per unit of capital DG; the rate of monetary expansion per unit of effective labor g-n; and open-market operations and debt management policies of the treasury DO. Equation (38) describes the dynamic model in terms of a vector-matrix differential equation whose components are equations (14), (15), and (37). Let vector X=(x1, r, 7r*) and C=(DG, ,.-n, DO). Then equation (38) can be written compactly as (39). A flow chart (Figure 3) is helpful in visualizing this system of differential
13 An easy way to do it is to assume that effective labor supplied grows exogenously at rate n. Then
where ,u is DM/M the rate of monetary expansion and DKIK is the growth of capital. Since x,-=AN8 K is assumed to be relatively constant in the short run and effective labor AN, grows at rate n, equation (35) can be used in place of (34). Dm (35) m
= ,u-7r-n
The current rate of price change ir in equation (33) depends upon m, which is the integral of past policies.
rt m(t)
= m(O)
expf
r)
7r(T)
n)dr
For this reason the economic system responds slowly to current monetary policy described by A(T)),in contrast to the models where consumption depends upon disposable income. Differentiate (33) with respect to time, and derive equation (36): (36) Dir = PjDU + P2Dir* + P3 + P4DG + P5DO Substitute (35), (15), and (14) into (36) and derive differential equation (37). When the long-run (or full) system is considered, then (34) rather than (35) will be substituted into (36); and DKIK will replace n. (37)
Dir =-P1/1h1x1+ (P2b-P131-P3)r
Dm m
(a)
Dx,/x, = it - DK/K
Outside the steady state, planned savings need not equal planned investment. Assume that the growth of capital is a linear combination of planned savings and planned investment, as described by equation (b). (b) 1 > a >O DKIK = aI/K + (1 -a)S/K, The complete model can now be reduced to four differential equations in four state variables: U, 7r, 7r*,and x,; and the phenomena of unemployment and price changes are viewed in the context of a growing economy. See the author, Keizo Nagatani, and H. Rose. 14 There is really another instrument that has been suppressed for the sake of simplicity: the distribution of government purchases between goods and direct labor services, ratio G1/G. The taxes less transfer payments are implicit in the model via the government budget constraint.
+ (P131 - P2b) ir*

+ (P4
-
P1,32)DG+ P3(, -n)
+P5DO
VOL. 64 NO. 6
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877
FEEDBACK
expected rate of
z o
o B '9 0:
nominal '
COST PUSH
A
uSti wageK
rate of
price
Z
,change
H
real wa > balances ~z i1~~~~~~~ ~~~~~~~H< I rate of monetary ~LCONTROL ~~expansion: E realI wage F unemployment rate-Ufor
o
Li.
a.
L G excess demand goods
Real Government Purchases: G CONTROL

FIGURE
3. THE
MACRo-ECONOMIC
MOLEL:
EQUATION
(38)
(38)
LD1
- Pil-P3) 11P1(P2b
+ (P4 -112) _ O 3 P5
(P1fl1-
P2b)jLw1
D-n
O O_ - Do
(39)
DX
AX+
BC
878
DECEMBER 1974
equations. Wage change equation (6) is described by link B (price expectation term) and link H (the unemployment rate). Price change equation (33) is the sum of the cost push link C and demand pull link L. The adaptive expectations equation is link A. Price change expectations operate on prices directly through links B and C, and indirectly through link D, the excess demand for goods. The unemployment equation consists of links F and the lefthand side of link I. Two policy inputs are depicted in the flow chart. Real government purchases of services operate directly upon the unemployment rate via the left-hand side of I; and real government purchases of goods operate upon the excess demand for goods, the right-hand side of link I. The second policy input is the rate of monetary expansion, link J. Changes in the rate of monetary expansion operate on money balances, and the excess demand for goods is affected via link K. Monetary policy can affect the unemployment rate indirectly by changing the real wage through link E. The circuitous route connecting monetary policy to the unemployment rate runs from J to K to E to F. A. Characteristics of the Steady State Define the steady state as a situation where the state variables X are constant (DX=O) and control variables DG and DO are zero. It is not assumed that A-n is zero. What are the characteristics of the steady state? Let subscript e denote steady-state values. Figure 2 is helpful in understanding the nature of the steady state. When the expected and actual rates of price change are equal, then (6) or (7) states that the growth of the real wage is negatively related to the (DW/W-7r)e unemployment rate; and it is described by the curve in the lower part of Figure 2. When the unemployment rate U and real government purchases per unit of capital are constant, then according to (10), the
real wage growth of ployment real wage That is:
will rise at the trend rate of productivity a. Only at unemrate Ue will the growth of the (DW/W-Fr)e be equal to a. a
=
(40)
(DW/W -
7r)=
h(Ue)
Therefore, the equilibrium unemployment rate Ue depends upon the h function and the rate of technical progress a: the higher the rate of technical progress, the lower will be the equilibrium rate of unemployment. The upper part of Figure 2 is based upon equation (9). It states that the unemployment rate is positively related to the adjusted real wage w* = wIA (t) and negatively related to the level of G. If there were a rise in G from G1 to G2, then the level of unemployment corresponding to w* would decline from Ue to U'. However the real wage would rise at a faster rate than a if the level of unemployment fell below Ue. The rise in the real wage would lead to a decline in employment in the private sector; and the unemployment rate would rise above U'. Equilibrium would prevail when the real wage rose to w* (point C). The transfer of labor to the labor-intensive G sector would raise the real wage, but no change would occur in the unemployment. The equilibrium adjusted wage w* = wIA (t) is given by equation (41). It is a function of Ue and G. (41) H- (Ue) =f(w* G)
=
H-[h-l(a)]
Two other important results occur in the steady state. There will be a zero excess deman for goods per unit of capital. This can be seen from (16), repeated here. (16)
r = DWIW-a-
+XpE
When the real wage grows at a, then (42) E(U, 7r*,m; G, 0, x,) = 0
The market for goods will be in equilibrium.
VOL. 64 NO. 6
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Finally, the equilibrium rate of price chanlge 7rewill be such that real balances per unit of capital will be constant. This follows from equation (36) or (37) when ThenP3 (- n-7) xl=w7r-7r*=DG=D6=O. =0. Since P3 is not zero,
(43)
7e =u-
The rate of price change is equal to the rate of monetary expansion less the growth of effective labor. The excess demand for goods must be zero when the steady state is attained. Therefore,
E(Ue, 7e,
mte;
G, 0, x8)
A n, me; G, 0, x8) = 0
= E(Ue,
ployment rate will converge to the equilibrium Ue as described in (13). It is convenient, but not necessary, to assume that there is an equilibrium rate of unemployment which is independent of the rate of price change; i.e., that (ho, hi, a) in equation (13) are quite stable and are not significantly affected by macro-economic monetary and fiscal policy. We know (Section IIA above) that w 7* =,= u=-n in the steady state. To describe (38) in two dimensions so that a phase diagram can be used, it is useful to define a new variable z: the difference between the equilibrium rate of price change and current expectations. In the 7e=A-n steady state, z will be zero. (45) z = (,u-n)-r* or r* = u-n-z
Solve this equation for me and obtain the equilibrium level of real balances per unit of capital. In this manner, the entire system is solved for its steady-state properties. Assume that: (a) the Routh-Hurwitz conditions for dynamic stability are satisfied, and (b) each element along the principal diagonal of matrix A is negative. The second assumption states that if (n- 1) state variables are fixed at their equilibrium values, deviations of the nth variable from its equilibrium value will be eliminated asymptotically. The second assumption is convenient, but not necessary, for the subsequent dynamic analysis. III. Unemployment and Inflation A. A nalytical Techniques A graphic explanation of the unemployment cum inflation phenomenon can be presented through the use of phase diagrams, which are based upon vectormatrix differential equation (38). Write the first equation in (38) as:
(44) Dxl = (-31jh)x1
-
Substitute (45) into the first equation of (38) and obtain (46). (46) Dxi = (-Olhl)
1lZ
-
-Xi
17-r +
31(&L -
n)
f2DG
Define the EE' curve as the set of (xi, r) along which Dx1 = O. It is equation (47) below. (47)
7r =-hlxl
(,-u-n-z)-
DGC
f13r + f17r*
02DG
This curve is negatively sloped. Why? If xi rises, the rate of growth of the nominal wage declines by h1Ax1units. If the rate of price change declined by the same amount, the adjusted real wage (w /A(t)) would be constant; and hence the unemployment rate would not change. For this reason the EE' curve is negatively sloped. Deviations of x1 from the EE' curve, given 7r, tend to be eliminated because it was assumed that each element along the principal diagonal of (38) is negative, i.e., it was assumed that (48)
(Dxl
When 7r-7r*=DG=O, then xi will converge asymptotically to zero; the unem-
ox, 7 Ox1
= -lh
< 0
880
DECEMBER 1974
The horizontal vectors in Figure 4 describe this phenomenon. What is happening in economic terms? If unemployment rate deviation xl is to the right of the EE' curve, the proportionate rate of change of the nominal wage will decline by hi units. Thereby, the growth of the adjusted real wage will decline by hi units. For every percentage point decline in the adjusted real wage, the employment rate will rise by /1 units (equation (10)). It follows that deviations of the unemployment rate from equilibrium tend to be eliminated, given the values of the other state variables. Disequilibrium in the labor market (xi #0) will produce repercussions upon the commodity market which, in turn, will affect the rate of price change; and thereby the labor market will be disturbed. Some of these effects will now be discussed. Write the second equation in (38): Dir = (-31h1P1)x1 + (P2b ? (Pil3
+
[(-P4 -
stable; and the elements along the principal diagonal of matrix A are assumed to be negative such that inequality (51) is satisfied. &Dir (51)
= 9r xI -(PI01
+ P3-P2b)
< O
Pfl3
P3)w
P2b)r* P1f2) DG + P5 DO]
+ P3(
-n)
= Substitute 7r* ,-n-z equation and derive:
into the above
(49)
Dr = (-O1ihP1)x1
? (P2b - P1t1 - P3)w ? (Pl?l + P3-P2b)(,u-n)

-
(Plil
(P4
-
P2b)z + P5DO
P1g2)DG
Define the PP' curve as the set of (xi, 7r) such that Dr= 0. It is described by equation (50) and is drawn in Figure 4.
(50)
+ [(P4
ir =(P3 +
-
-/hk1P1
P131 - P2b) P112)DG + P5DO - (Pl,

(P3 +
-x
P2b)z]
P131 -
P2b)
The dynamic system is assumed to be
The vertical vectors in Figure 4 describe this phenomenon. Given x1, deviations in 7r tend to be eliminated. A unit rise in wr above the PP' curve induces three distinct forces: some tend to produce further deviations of 7r, and others tend to restore it to its equilibrium value. These basic forces are reflected by P13l, P3, and P2b and are described graphically in the flow chart (Figure 3). (a) First: A rise in 7r raises the expected rate of price change by b units. Two subeffects are produced: one in the labor market and the other in the commodity market. The rise in the expected rate of price change raises the growth of the nominal wage; and the latter raises costs. Moreover, the rise in the expected rate of price change raises planned investment because the real rate of interest tends to decline relative to the rent per unit of capital. The increase in the excess demand for goods exacerbates the rate of inflation. As a result of a unit deviation of the rate of price change from equilibrium, the expected rate of price change rises by b units; and the rate of inflation is raised by bP2= b(1 +X,E2) units. This is an element of instability. (b) Second: A rise in 7rtends to lower the growth of the adjusted real wage; and unemployment tends to decline by /1 units. Several countervailing effects, summarized by -O3P1i=(iz(h1-X,Ei), are produced: (i) The growth of the nominal wage is increased by /1h1 units and the resulting rise in costs is passed on in the form of a higher rate of price change. Inflation is aggravated. (ii) The decline in unemployment increases output; and both savings and
VOL. 64 NO. 6
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881
El
Pi~
E2s
~ ~ ~ ~~~i
Eo\~~~~~~~~~~~~E
FIGURE 4. THE STEADY DECLINE IN G(DG<O) AND THE RISE IN THE RATE OF MONETARY EXPANSION (,U) INDUCE THE ECONOMY TO FOLLOW TRAJECTORY OT. THERE IS INFLATION AND UNEMPLOYMENT. WHEN G LEVELS OFF, THE ECONOMY WILL HEAD BACK TO POINT A WHERE (Xi, r) = (0, ,U-n)
investment rise. The rise in savings tends to reduce the rate of inflation, whereas the rise in the rate of investment tends to increase the rate of inflation. It is not obvious on a priori grounds whether excess aggregate demand rises or declines; i.e., what is the sign of E1? If the savings function is steeper than the investment function, when both are shown as functions of income, then E1 is positive. Excess aggregate demand will decline; and the inflation will be mitigated. (c) Third: A rise in the rate of price change produces a negative real balance effect. The real value of money and debt holdings is reduced. Aggregate demand is affected directly through consumption and indirectly through the liquidity pref-
erence function. The net effect is to reduce excess aggregate demand and lower the rate of price change. Term - P3=mXpE3 is an element of stability. It is assumed that the stabilizing forces predominate: >O, and (P3+P1f1-P2b) that the full Routh-Hurwitz conditions for stability are satisfied. If the system is to be dynamically stable, then it is necessary that the slope of the PP' curve be algebraically greater than that of the EE' curve. The slope of the PP' curve will depend upon the sign of an effect which was dis-Pi=hf-XPE,, cussed above. In Figure 4, the PP' curve is drawn with a negative slope;15 but the
15 Preliminary empirical work suggests that the PP' curve is negatively sloped and that the system is dy-
882
DECEMBER 1974
analysis would be similar if it were positively sloped. B. The Phenomenon Explained It is convenient for graphic exposition (but not necessary for an algebraic analysis) to make a monetarist assumption (to be discussed in Section IV below) that [(P4-P1i2)DG+P5D0], in equation (50) describing the PP' curve, is approximately zero. Moreover, assume that the numerator of the coefficient of z (Plfl -P2b) / is sufficiently small as (P3+P101-P2b) to be ignored.16 Then the EE' and PP' curves can be described by equations (52) and (53), respectively. (52) (53) wr=-hixi+ r=1- _ [(,-n-z)--DG] SU-n
P3
When Mo-n=z=DG=0, the EE' curve will be described by EoEo and the PP' curve will be described by P0P' in Figure 4. The resulting equilibrium (xi, r) = (0, 0) is stable. Suppose that real government purchases of goods and services per unit of capital were declining (DG <0), but that the rate of monetary expansion increased from .o0= n to ei. What will be the effects upon unemployment and inflation? The decline in G shifts the EE' curve (equation (52)) upwards from EOE'. To maintain a given rate of unemployment, a rise in the rate of inflation is necessary to lower the growth of the real wage. In this manner the private sector would absorb the decline in the government's demand for labor services. Or given 7r, the unemployment rate increases when G declines. The new
namically stable. This means that the conventional textbook case, where the savings function is steeper than the investment function, seems to be true. 16 This assumption reduces the amount of curve shifting required for graphic exposition.
EE' curve that results when DG <0 but the forthcoming inflation is unanticipated has not been drawn in (z=1yi-n-O) Figure 4; just keep in mind that it is above EOEo. The PP' curve (equation (53)) will be shifted up to the right from POPO P,P', to as a result of the rise in ,-n. Why? Given the rate of inflation, only a rise in the unemployment rate can offset the inflationary effect of rising real balances upon excess aggregate demand. Alternatively, real balances per unit of effective labor will be constant only if wr rises to p1-n; hence, the PP' curve shifts upwards. Initially the unemployment rate and rate of inflation rise. The latter increases because the growth of real balances raises the excess demand for goods by more than the greater softness in the labor market reduces the growth of the nominal wage. The sum of the two effects, DG<O and the anticipated inflation (z-*O), shifts the EE' curve to EAEl. When the inflation is anticipated, the E1E' curve is: wr=hxl+ When DG<O, the (,u-n)-(f21f1)DG. intercept of E1E' exceeds the intercept of the P, PI curve. Figure 4 describes the resulting situation. The economy will head along trajectory OT to point T. Both unemployment and inflation will increase as long as DG < 0 and y- n > 0. The paradox is easily explained within the context of this model. When G stops declining and levels off (DG=O), then the EE' curve will shift to E2EA. The intercept will be at point A = (O, lu1-n). As a consequence of the levelling off of G, the economy will head for point A in Figure 4 along a trajectory such as TA. If the speed of response in the labor market (h1) is slow, it may take some time to reach equilibrium. The Keynesians question the ". . . ability [of an economy] to return automatically to full employment equilibrium within a reasonable
VOL. 64 NO. 6
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time (say, a year) if it is subject to the customary shocks and disturbances of a peacetime economy" (Patinkin, p. 901). Clearly, a graphic description of a third order (3x3) system can only sketch its basic features. However, this model has been shown to be capable of explaining the qualitative features of the unemployment cum inflation paradox. IV. The Monetarist Controversy The dynamic model developed above can also explain the issues involved in the monetarist controversy. Thereby, the controversy about the roles of monetary and fiscal policies can be reduced to an econometric debate about empirical magnitudes. The crucial propositions held by sophisticated monetarists can be briefly stated. Mi. "Changes in the pace of economic activity are not associated with any particular monetary growth and occur independently of the level of monetary growth. They only depend on the previous changes in monetary growth, whatever its inherited level" (Brunner, pp. 14-15). M2. "The impact of monetary accelerations (or decelerations) on output and employment is essentially temporary" (Brunner, p. 13). M3. "Monetary growth affects dominantly the price level" (Brunner, p. 13). M4. "The slope of the LM curve is not the key difference between the monetarists and the neo-Keynesians" (Friedman, p. 910). M5. "To have a significant impact on the economy, a tax increase must somehow affect monetary policy-the quantity of money and its rate of growth. Whether deficits produce inflation depends on how they are financed. If, as so often happens, they are financed by creating money, they unquestionably do produce inflationary pressure. If they
are financed by borrowing from the public, at whatever interest rates are necessary, they may still exert some minor inflationary pressure. However, their major effect will be to make interest rates higher than they would otherwise be" (Friedman, p. 915). M6. "Government spending unaccompanied by accommodative monetary expansion, that is financed by taxes or borrowing from the public, results in a crowding out of private expenditures with little, if any, net increase in total spending" (Andersen and Carlson, p. 8). The monetarists could accept the differential equation for the unemployment rate: Dxl
= (-Olhl)xl
-
/13 +
lwr* -
f2DG
If the government does not hire labor directly, but just purchases goods from the private sector, then G1=O. This is the usual case considered by the monetarists; however, I wish to consider the general case where the government purchases both goods and services. The monetarists make the following assumptions: (a) There is an equilibrium rate of unemployment which is independent of the rate of price change. It is their contention that (ho kil, a) in equation (13) above are quite stable, and are not significantly affected by macro-economic policy. This assumption is'necessary to derive monetarist conclusions. The EE' curve is equation (47), repeated here.
(47)
=r
-h1x1
+ [(u -
-s
z)
DG]
(48)
aDxl -lh, ax1
< O
(b) The expected rate of price change tends to adjust to the current rate with a
884
DECEMBER 1974
lag. Otherwise, monetary policy would not be able to exert even a temporary effect upon the unemployment rate. That is, if 7r*(t) = 7r(t) for all t, and DG(t) =0, then xl(t) will converge asymptotically to zero, 17 regardless of the rate of price change or the nature of current monetary policy. (c) concerns the PP' curve. In general, the PP' curve is equation (50) repeated here.
(50)
-1i
thereby raises interest rates. The latter crowds out private investment. The monetarist position may be interpreted to claim that in equation (50) the term in square brackets [(P4-Pl,f2)DG+P5DG] is sufficiently small that it can be ignored.'8 This phenomenon has nothing to do with the slope of the LM curve but is concerned with its upward shift resulting from a rise in 0, the ratio of private financial wealth to the stock of money. Monetarists could write the price change equation as (54). (54) D7r= (-d31h1P1)x,1-(P3+P1,i31-P2b)7r
+ (PlO31- P2b) 7r* P3 ( +
-
(P3+P1,i1-P2b)
(A-n
+ [(P4-P1p2) DG+P5D0]
(P3+P101-P2b)
n)
(Pjl3
dD7r
P2b)z
(P3+P1,1-P2b) (51) 71
Again, it is convenient for graphic purposes to assume that the coefficient of z in (50) is small so that the PP' curve can be described by (55). <0 (55)
Jr- =Cu-n)
(P101+P3-P2b)
1h,P,
P3
The monetarists argue that a rise in G, unaccompanied by a rise in the rate of monetary expansion, steadily raises the financial wealth-money ratio 0. Consequently the demand for real balances rises for two reasons: (i) A rise in G tends to raise the transactions demand for real balances directly. (ii) A steady rise in 0 continues to raise the demand for real balances, because money and financial wealth are complementary assets in the portfolio. As a result of the rise in the demand for money, the LM curve keeps shifting upwards steadily and the nominal rate of interest rises and "crowds out" private investment. On balance the excess demand for goods does not change by much. Similarly, a decrease in taxes unaccompanied by a rise in the rate of monetary expansion raises wealth and induces an increase in spending. But it also increases the supply of securities or demand for money, and
17 If .r*(t) = 7r(t) for all t, then the first equation in (39) is: Dxi= -3i/lixi or xi(t)=xi(O) exp (- 31,ht). It is
The EE' and PP' curves used in Section III above were based upon the monetarist model. To repeat, the crucial monetarist assumptions are that: (a) Vector (ho, hi, a) is independent of monetary and fiscal policies, i.e., Ue is independent of these policies. (b) Expectations change slowly.
18 The St. Louis monetarists suipport their contention on the basis of the following regression (Andersen and Carlson, p. 11):
A Y(t)
4
2.67 5.57
E
i=O
miAAM(t i) + E eiAE(t
i=O 4
i)
E
i=o
ni=
t = 8.06;
E ei = .05
i=O
t = 0.17
independent of monetary shocks.
where AY(t) is the dollar change in GNP in current prices in the t-th quarter; AM(t-i) is the dollar change in the money stock in quarter (t-i); and AE(t-i) is the dollar change in high employment federal expenditures in quarter (t-i). Alternatively, the monetarist position could be interpreted as claiming that P5 is negative although the term in brackets is not negligible. Consequently, if G rose and then levelled off, the deficit financed by selling bonds would constantly raise 0. That is, DG becomes zero, but DO remains positive. Therefore, deflationary pressure would be exerted (Dwr<O)which would offset the initial rise in G.
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(c) Quantity [(P4-P1/2)DG+P5DG] is approximately equal to zero so that government expenditures financed through the sale of debt do not exert a perceptible effect upon excess aggregate demand. A diagrammatic explanation of the monetarist conclusions (M1-M4) can also be given on the basis of the above model summarized by equations (47), (48), (55), and (51). Suppose that ,-n=DG=z=O. Then the EE' and PP' curves are described by the EEo and PoP' curves, respectively, in Figure 5. Both curves intersect at the steady-state solution, which is the origin in this case. The system is assumed to be
stable. Directions of motion are described by the horizontal and vertical vectors; and the economy will converge to the
steady state x1=0,
7re= 7r*=
-n=fO.
The
trajectory is easily described on the basis of the phase diagram. Assume that the economy is initially in equilibrium at the intersection of the EOE6and POP' curves. Then let the rate of monetary expansion per effective worker accelerate from zero to ,u-n= OA > 0 in Figure 5. If expectations change slowly, then the forthcoming inflation is not yet anticipated and z = ,-n-7r*= ,-n-O= ,u- n. Graphically, the EE' curve does not shift. Solely for the sake of geometric simplicity, assume that the coefficient of z in equation (50) is sufficiently small as to
7T
El
Eo~~~~~~~~~E
FIGURE 5. WHEN THE R{ATE OF MONETARY EXPANSION PER EFFECTIVE WORKER IS RAISED FROM ZERO TO QA, THE ECONOMY FOLLOWS TRAJECTORY OBCA TO THE STEADY STATE (xG1, = (0, ,~-n). GRAPHICALLY THE EE' CURVE T) SHIIFTS ALONG P,Pt
TO 1E,A (FROMEOEO)
886
DECEMBER 1974
be ignored.19 Then the POP' curve will shift up by the full amount of the rise in the rate of monetary expansion. Real balances per worker start to rise; and the excess aggregate demand is increased. The economy starts to head from the origin to the temporary equilibrium point T in Figure 5. Why? As a result of the rise in real balances, excess demand increases; and the rate of price change is raised. The inflation reduces the growth of the real wage, and thereby increases the rate of employment. For this reason, xl declines and 7r rises as the economy heads from the origin to point T. As the inflation proceeds, inflationary expectations develop. This means that z=,-n-7r* decreases. In graphic terms, this means that the EoEo curve starts to rise towards E1E', as wage negotiations are based upon a higher rate of anticipated inflation. The rising EE' curve implies that the economy will eventually head for point A, at the intersection of the P1P' and E1EA curves. Trajectory OBCA may describe the motion of the economy to the new equilibrium point A = (xi, 7r)e (0, g-n). Monetarist conclusions are thereby obtained. The monetary acceleration reduced the unemployment rate temporarily below the equilibrium rate. The absolute rate of monetary expansion per effective worker only affects the steady-state rate of price change; but there is no relation between unemployment rate x1 and the constant rate of monetary expansion per worker at the steady state. Compare the origin with point A. Unemployment can be kept below Ue, i.e., xi can be kept negative, only if the process is repeated. That is, the rate of monetary expansion must be raised steadily; and this leads to hyperinflation. This
19The net effect is that, initially, the PP' curve shifts up by more than does the EE' curve. The assumption in the text describes this result with a minimum curve shift.
model can imply monetarist conclusions. If the term [(P4-P1/2)DG+P5DO] were positive, then "weak monetarist" conclusions would follow. A steady rise in government expenditures (DG >O) financed through the sale of bonds would raise the rate of price change and reduce the level of unemployment. The PP' curve would shift upwards and intersect the EE' curve in the second quadrant. However, if the level of government expenditures then stabilized (DG =O) but P5 <0, then the crowding out effect would occur. The rising ratio of financial wealth to money would raise interest rates (the LM curve would shift upwards) and adversely affect the excess demand for goods. Graphically, the PP' curve would be shifted downwards when DG declines but DO remains positive. Therefore, the monetarists would claim that government expenditures produce expansionary effects only if they are financed by the creation of new money. A fiscalist on the other hand would claim that P5 is positive. A rise in 0 (say, resulting from a tax reduction where the deficit is financed through bond sales) would stimulate excess aggregate demand. To be sure the rise in 0, the ratio of bonds to money, would raise the nominal rate of interest by shifting the LM curve upwards. However, the rise in the debt would increase consumption demand, and shift the IS curve to the right. The net effect of a rise in 0 will be expansionary if the IS curve shifts upwards by more than does the LM curve or if the IS curve is interest inelastic. Then P5 will be positive. The monetarists would deny that this occurs. I have shown what empirical specifications imply monetarist or fiscalist conclusions; and the controversy can be reduced to a set of testable propositions. REFERENCES L. C. Andersen and K. M. Carlson, "A Monetarist Model for Economic Stabilization,"
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STEIN: MONETARISM
887
Fed. Reserve Bank St. Louis Rev., Apr. 1970, 52, 7-71. K. Brunner, "The Monetarist Revolution in Monetary Theory," Weltwirtsch. Arch., 1970, Part 2, 105, 1-30. and A. Meltzer, "Friedman's Monetary Theory," J. Polit. Econ., Sept./Oct. 1972, 80, 951-77. 0. Eckstein, The Econometrics of Price Determination Conference, Washington 1972. M. Friedman, "Comments on the Critics," J. Polit. Econ., Sept./Oct. 1972, 80, 90650. R. J. Gordon, "Inflation in Recession and Recovery," Brookings Papers, Washington 1971, Z, 105-66. E. Infante and J. L. Stein, "Optimal Growth with Robust Feedback Control," Rev. Econ. Stud., Jan. 1973, 40, 47-60. J. M. Keynes, A Treatise on Money, Vol. I, London 1930. D. Laidler, "Simultaneous Fluctuations in Prices and Output-A Business Cycle Approach," Economica, Feb. 1973, 40, 60-72. R. E. Lucas, Jr. and L. Rapping, "Real Wages, Employmentand Inflation,"J. Polit. Econ., Sept./Oct. 1969, 77, 721-54. K. Nagatani, "A Monetary Growth Model with Variable Employment," J. Money, Credit, Banking, May 1969, 1, 188-206. D. Patinkin, "Friedman on the Quantity Theory and Keynesian Economics," J.
Polit. Econ., Sept./Oct. 1972, 80, 883--905. E. Phelps, "The 1972 Report of the President's Council of Economic Advisers: Economics and Government," Amer. Econ. Rev., Sept. 1972, 62, 533-39. H. Rose, "Unemployment in a Theory of Growth," Int. Econ. Rev., Sept. 1966, 7, 260-82. P. Samuelson, "The Role of Money in National Economic Policy," in Controlling Monetary Aggregates, Monetary Conference, Federal Reserve Bank of Boston, June 1969. J. L. Stein, "Money and Capacity Growth, New York 1971. and E. F. Infante, "Optimal Stabilization Paths," J. Money, Credit, Banking, Feb. 1973, Part II, 5, 525-62. J. Tobin, "'Commentsand Discussion: The Fellner, Okun, and Gordon Reports," Brookings Papers, Washington 1971, 2, 511-14. Mecha, (1972a) "The WVage-Price nism: Overview of the Conference," in 0. Eckstein, ed., The Economietricsof Price Determination Conference, Washington 1972. -- , (1972b) "Inflation and Unemployment," Amer. Econ. Rev. Mar. 1972, 62, 1-18. , (1972c) "Friedman's Theoretical Framework," J. Polit. Econ., Sept./Oct. 1972, 80, 852-63.

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Unemployment, Inflation, and

nomic Advisers.[pp. 533--34]

THE AMERICAN ECONOMIC REVIEW

DW~ ~~X *XI2(Va

H' < 0; (4) H-1(U) =

The actual ratio of effective labor em-

THE AMERICAN ECONOMIC REVIEW

+ (11) DU = ,01(7r* h(U) -7r

and services per unit of capital.5

2DG (H-1) '

' where,B1=-f1(H-1)wlA > 0; 02=--f2/-

THE AMERICAN ECONOMIC REVIEW

- aI3a + aI47r* + f(U

will be terse, since it is largely based upon my 1971 study.

demand price of capital

supply price R(t) P*(t) P(0)

C. The Excess Demand for Goods

n+ g(r 7r* -P)+a + -

THE AMERICAN ECONOMIC REVIEW

y' > O, y" < O

=S(y, m, 0); 1 >S1>O, S2<O, S3<O

= n + g[R(U; xs) + wr*--p] S[Y(U; xs), m, 0] + G

A11 (k) f"'(k)

875 p = g(U, 7r*, m, 0);

THE AMERICAN ECONOMIC REVIEW

+ (P131 - P2b) ir*

P1,32)DG+ P3(, -n)

L G excess demand goods

Real Government Purchases: G CONTROL

THE AMERICAN ECONOMIC REVIEW

real wage growth of ployment real wage That is:

The market for goods will be in equilibrium.

When 7r-7r*=DG=O, then xi will converge asymptotically to zero; the unem-

THE AMERICAN ECONOMIC REVIEW

P2b)r* P1f2) DG + P5 DO]

= Substitute 7r* ,-n-z equation and derive:

into the above

? (P2b - P1t1 - P3)w ? (Pl?l + P3-P2b)(,u-n)

P131 - P2b) P112)DG + P5DO - (Pl,

The dynamic system is assumed to be

THE AMERICAN ECONOMIC REVIEW

aDxl -lh, ax1

THE AMERICAN ECONOMIC REVIEW

independent of monetary shocks.

steady state x1=0,

THE AMERICAN ECONOMIC REVIEW

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