New Classical Macroeconomics as Monetarism Mark II

At its heyday in the 1980s, new classical macroeconomics (NCM) was widely considered to have accomplished the monetarist campaign against Keynesianism. This campaign had been driven most forcefully by Friedman (1968) in his well-known presidential address to the American Economic Association: monetary policy cannot establish and maintain any inflation-unemployment combination on a given Phillips curve at will, because adaptive inflation expectations let the curve shift upwards (in case of an expan­sionary monetary impulse).

As Friedman left no doubt that he discussed a scenario where policy aimed to keep unemployment below the natural rate, it remains a mystery why Keynesians felt the need to object to this monetarist attack. The “discovery” that money growth beyond the point of full employment will necessarily lead to inflation without increasing output can already be found in the General Theory (Keynes 1936 [1973]: 303). There is hardly any deviation from Friedman’s acceleration principle, although it has to be conceded that a systematic treatment of inflation expectation is missing in Keynes (but note that trend inflation is a post-World War II phenomenon).

A reasonable understanding of Friedman’s scenario would build on a realistic assump­tion of data uncertainty: when suffering from an imprecise estimation of the natural rate, policymakers, as in Wicksell’s (1898: 189) early recommendation for interest rate policy, learn only by a rise or fall in the price level about deviations from equilibrium.

The same is true with regard to hysteresis: there is an incentive to increase employ­ment beyond the current natural rate if that level is endogenous, but this argument was missing in Friedman’s attack on Keynesian demand policy. Friedman provides no detailed explanation of how the natural rate is determined, he simply contends that it results from the Walrasian system of general equilibrium equations. According to Lucas (1980: 709), owing to a lack of analytical capabilities Friedman is “not able to put such a system down on paper”, and, according to McCallum (1989), the natural rate hypothesis is not incompatible with hysteresis as it is not monetary policy as such that changes the NAIRU, but endogenous mechanisms of human capital building triggered by a mon­etary policy impulse.

Taking Friedman’s scenario as the stage, Lucas and the NCM, named Monetarism Mark II by Tobin (1980), offered a more radical play where agents immediately jump to their new equilibrium positions whenever they expect rationally that the policymaker is about to increase the money growth rate. As a consequence, there are not even tem­porary employment gains during a monetary expansion. There is no Phillips Curve that can be exploited on the part of an employment-oriented policymaker. What comes as a

surprise, however, is that Hahn (1982: 74-5) seemed to be the only person who under­stood that, so far, the Keynesian camp should not be bothered by the messages of both Friedman and Lucas:

It is puzzling to find it put forward as a discovery that a higher inflation rate will not increase the full-employment level of employment: Keynes and Keynesians would not have claimed otherwise... The Lucasians, by denying the possibility of involuntary unemployment - indeed, they profess not to know what it means - have given no reason why anyone should be interested in their trade-off even if it existed. In fact, the world that they describe quite plainly needs no macro-policy. Keynesians were concerned with the problem of pushing the economy to its natural rate, not beyond it. If the economy is already there, we can all go home.