An Introduction to Positive Economics - Essay Example

Fluctuations in Output and Unemployment due to imperfect information. Milton Friedman Fooling Model / Robert Lucas Price Surprise Model Milton Friedman is considered to have been one of the most influential economists of the 20th century by The Economist. He is best known for looking at money supply as determinant of the nominal value of output. His research into relationship of money supply fluctuations and economic fluctuations lead to conclusion that the Great Depression was caused by government mismanagement of money supply. He argued that an ordinary financial shock was greatly increased in seriousness due to the subsequent contraction of money supply caused by the misguided policies of Federal Reserve (Wikipedia, 2006). Friedman believed and advocated Economics as a science which should be judged by its simplicity and fruitfulness as an engine of prediction. As a monetarist, Friedman developed a model, utilized the concept of agent’s expectations and their effect on economic output. Rational expectations makes the strong assumption that agents are smart and can anticipate future changes in the price level, money supply etc. based on current economic conditions or past behavior, whereas in Keynesian model, agents were not smart and could not rationally anticipate future changes. The model assumes that workers are not able to observe the current price level and therefore rely on rational expectations of the price level based on previous periods. According to the model, unexpected changes in price levels lead to changes in output because workers are slow to notice the price changes. An unnoticed increase in prices would also mean unnoticed associated drop in the real wage of the labour. Thinking that the real wage is higher than it really is, more labour is supplied than would be if full information was available, leading to increase in output in short term based on imperfect information. The model is occasionally referred to as the ‘fooling model’. Firms demand more labour because real wage has fallen – the nominal wage however increases. Since workers are currently only aware of nominal wage, they are ‘fooled’ into believing that the real wage has risen and provide more labour. Output increases from the natural rate because workers and firms have different belief in what the real wage is equal. Consequently if the real wage increases, workers are not able to immediately detect the change and believe that the real wage is lower than it actually is. Workers supply less labour in this scenario and output falls below the natural rate. If Federal Reserve surprises the economy by increasing money supply, the aggregate demand increases causing the price level and output to increase. In the labour market, the increase in price level is not observed and neither the decrease in real wage. Worker, believing that real wage is higher than it actually is, are willing to supply additional labour than they would have for the real prevalent wage (graphical depiction would be the shift of labour supply curve to the right). The actual real wage rate decreases but workers believe that the real wage has increases since the nominal wage has increased. Eventually the discrepancy would be realized by the workers and being rational agents would be able to figure out the new wage level for their labour. In case if Federal Reserve’s action is anticipated, workers will immediately increase their expectations to the new price level. Since the workers expected increase in money supply leading to increase in prices, they are never fooled in to believing that the real wage rate has changed and don’t supply too much labour. Output does not change. The market adjusts itself in short run when the changes are expected while in case where changes are not expected, the adjustment happens over medium term. In the Friedman’s model, only unexpected changes result in changes to output. Assuming that the money supply is increase consistently in an attempt to keep output above its natural rate. The workers will keep increasing the speed at which they adjust their expectations. Eventually expectations will adjust with the money supply and further increase in money supply will lead to increase in inflation without an increase in output. According to the monetarists, stabilizing monetary or fiscal policy (expected or unexpected) actually managed to cause recessions. As per Lucas theory, expected changes have no effect on output and only serve to change the price level. In the Keynesian model, business cycles could be better managed with prudent macroeconomic management. However in this model, if the workers can have up to date information of the true price level, output will tend to stay at its natural rate. Monetarists, such as Friedman, believe that the economy is inherently stable because private sector expenditure functions are relatively stable and price adjustment will bring the economy back to potential output. In addition they believe that changes in output are mainly dependant on policy changes in the money supply. A rough correlation between changes in the money supply and changes in the level of economic activity is accepted by economists however, more recent work has shown that the relationship is more of a broad association than a close correlation as resolved by Friedman and Schwartz. However Friedman and Schwartz maintain their argument based on Great Depression, that money supply causes changes in business activity which leads them to advocate a policy of stabilizing the growth of the money supply in order to avoid policy induced instability of output. According to new classical approach – aimed for models which defined the markets as always in equilibrium – only unanticipated policy changes lead to changes in real national income. Systematic policy changes will be predictable and will have no real effects (Lipsey). In Lucas approach, wages are not just given on the basis of last period’s equilibrium; rather they are set at the beginning of the current period at the market clearing level for given expectations of what output prices in the current period will be. In other words, they are set on the basis of forward looking expectations of what the market out come would be. A small modification had fundamental implications on the model. In such a model, any change in output that is expected at the time wages are set will automatically be factored in while determining the increase in wage. Essentially the economy will experience an immediate increase in price level and no increase in national income since the expectations are formed rationally. Even if cycles in real economic activity are triggered only by unexpected increases in the money supply, agents would learn from the pattern of mistakes and improve their forecasts. Lucas also added and adjustment process to his model that once shocked, the model behaved like any of the other cycle models. As per Lucas critique there will be shifts in many private sector behavior functions when there are significant changes in the policy regime. Hence the effects of such regime changes will be impossible to forecast accurately using conventional models. Lucas pointed out that historical models contain estimates of key behavioral parameters that were estimated from past data. Such model would generate inaccurate results when used to predict affects of major policy change, especially considering that behavior and expectation of agents may change based on behavior of policy makers. Most economists do not accept the proposition that only unexpected policy changes will have real effects. There is so much delay in price and wage setting behavior that very few contracts can be renegotiated as soon as policy change is announced. Therefore policy makers have some leverage over real activity even when making policy changes that are predictable. Also the massive complexity of the economy makes it impossible for individual agents to know how some shock will affect their prices and quantities over specific period of time. For example the direct effect of increase in money supply to the money multiplier for that change cannot be accurately predicted or how long will it take before the implemented policy will generate a reaction. If agents are watching the government and trying to from expectations of its future behavior, not only does it matter what the government will do, but also what the agents think it will do in the future. The government would need more than the correct policies for the current scenario, it will also have to establish credibility that it will follow similar policies in the future. A simple element of re-election can cause the government to break its original commitment and focus on more important aspects of economy. Of course the agents should anticipate the variables of such a scenario, but once the commitment is broken, re-establishment of credibility can be very hard. The idea of everyone knowing the exact nature of some policy disturbance and solving the equations of the economy to determine the exact outcome of their actions seems far fetched to many economists. Friedman and Luca both earned Noble Prize for their contribution to the field of economics. Their models are geared towards better explaining the business cycles and suggestion towards best possible course of action for policy makers with a trade off between output and inflation. The usefulness of the models is directly dependant on government identifying the most important economic issue that needs to be addressed. If the government has identified unemployment as the number one economic problem, then policy makers can implement the expansionary monetary policy. The sudden supply of money, even if it is known, will generate a ‘fooling’ effect, leading to increase in labour and eventual output. The expanding economy will lead to solving the unemployment problem, but will as the output starts to rise above its potential level, the price level will begin to rise which leads to inflation taking place of unemployment as the most important problem. The government will need to engineer a contractionary policy – reducing the output. Decrease in output will decrease the price level, curing the inflation problem but leading to increase in unemployment. Such solutions can be used for stop gap purposes even though it is generally accepted that any type of monetary policy will, when implemented, will take approximately a year to generate results. Lucas model argues that the systematic part of change in money supply would – under certain restrictions – not affect output. When the agents are informed of the policy changes, the monetary expansion will lead to inflation. However, as discussed above, even when full information is available, the implementation time line does create discrepancies in exact implementation of this model. The key policy result is that of Friedman that there was no long run trade off between output and inflation while adaptive expectations implied an exploitable short run tradeoff. Lucas showed that there would also be no short run tradeoff in such models if expectations were rational (Fisher). In today’s complex economic environment, there are a number of theories and schools of thought for economic policy making decisions. However, all of the models use some restrictions and / or constants. In real world, where all variables are constantly changing, these theories provide insightful analysis and guidance towards policy making and to avoid catastrophes such as Great Depression. Works Cited The Economist, 2006, ‘A Heavyweight Champ, at five foot two’, Economist [online] Available at: http://www.economist.com/business/displaystory.cfm?story_id=8313925 Friedman, M. and Schwartz, A. 1971, Monetary History of the United States, 1867-1960, Princeton University Press Fisher, S. 1996, ‘Robert Lucas’s Nobel Memorial Prize’, Scandinavian Journal of Economics, pg. 11 – 31 Wikipedia. 2006, ‘Milton Friedman’ [Online] Available at: http://en.wikipedia.org/wiki/Milton_Friedman Wikipedia. 2006, ‘Robert Lucas, Jr.’ [Online] Available at: http://en.wikipedia.org/wiki/Robert_Lucas_Jr. Lipsey, R. and Chrystal, K. 1997, An Introduction to Positive Economics, Oxford University Press, UK Read More