If It Ain't Broke . . .

Paul Krugman has a new Substack, and his first post revisits the famous cycle of rising inflation and disinflation during the 1970s and 1980s, which led to a revolution in macroeconomic theory. The subtitle is:

Did we get the whole macro story wrong?

I’m going to argue that the answer is “no”.

The model that won out in the 1970s and 1980s was mostly developed by monetarists like Milton Friedman, who argued that the Phillips Curve was an unreliable policy tool and that expansionary demand-side policies would have only a temporary effect on unemployment. Once expectations of inflation caught up to reality, unemployment would return to its natural rate.

Krugman suggests that he initially accepted much of this thesis, but now has some doubts. In my view, he’s focusing too much on the Keynesian interpretation of Friedman’s argument, which makes the data look more puzzling than it actually is.

In Friedman’s Natural Rate model, unexpectedly high inflation causes low unemployment and vice versa. The Keynesian version of the same model reversed the causation. Now it’s low unemployment (i.e. “economic overheating”) that causes high inflation.

To give a sense of how this distinction matters, consider this comment by Krugman:

The truth is that I’ve always been a bit uneasy about the standard story of inflation in the 1970s, even though it seemed to fit the prediction of clockwise spirals. My uneasiness came from the sense that the economy never seemed to run hot enough to explain such a big rise in inflation. I actually remember the 70s! And while there were years of good job markets, they never felt as good as the 60s, the late 90s, or 2019.

But that’s not at all a problem for the monetarist theory, as the monetarists always insisted that inflation was not caused by a hot economy, it was caused by rapid money supply growth. And monetarists also suggested that the effect would be quite transitory, with unemployment returning to its natural rate after a few years. And finally, the natural rate was itself volatile, and could not be used as a guide to stabilization policy. (To be fair, the preferred monetarist indicator, money supply growth, also eventually turned out to be faulty.)

Rapid growth money pushed unemployment down below 4% in the late 1960s, as inflation soared. This fits the monetarist model. Then it rose back to its natural rate during the 1970s, rising above that rate during occasional periods of disinflation or adverse supply shocks. This also fits the monetarist model.

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