Chapter Sixteen

A Monetary Phenomenon

The Power of Expectations

How Much Money is There?

This chart doesn't show up well on small screens. You can get a better look here: FRED MB

This question - How much money is there? - sounds like something a 5-year-old might ask. Like the 5-year-old, I imagine you don't really find the graph above to be a very satisfying answer. Even worse, the graph is just one of several answers we could give. The problem is: what money counts?

Open Video Transcript

The simplest answer to this question is given by what we call the Monetary Base, which is the total amount of currency. If you got your hands on all of the dollar bills and coins there are, you’d have about $6.4 trillion. About $4.2 trillion of that is sitting in bank vaults and in the reserves held with the Federal Reserve. So only about $2.2 trillion is actually in circulation. But this number is far from a satisfying answer to our question. That’s because it is nowhere close to the answer you would get if you went around and asked everyone how much money they had. That’s because a lot of the money we have has been created by lending. If you have $1,000 in your savings account, the bank has lent out a good portion of that money. If we ask people how much money they have, you’ll count that $1,000, but so will the person it is lent to. And so, if we want a functional understanding of how much money there is circulating in the economy, we need to take this into account. --The money supply is the total amount of money in circulation or in existence. We have three main measures of the money supply. The monetary base measures the total amount of currency in existence. That includes all cash and coins both in circulation – meaning in the hands of the general public – or sitting in bank vaults and the Fed. Then we have two measures which economists saw fit to bestow the inspiring names M1 and M2. Both M1 and M2 are only focused on money that is in circulation. So, M1 includes only the cash and coins in the hands of the general public but adds to them the money in people’s checking accounts and savings accounts. Since deposits made into checking and savings accounts can be lent out by banks, this will capture some of the money created through the process of lending. M2 goes further. It includes everything that is in M1 – cash, coins, checking accounts, and savings accounts – but adds Certificates of Deposit under $100,000 and individual money market accounts. Certificates of Deposit are a kind of savings account where a person agrees to deposit money with a bank for a specified length of time. The money in this account earns a set amount of interest each month, but the depositor agrees not to withdraw the money before the agreed upon time. Money Market Accounts are similar. These are savings accounts which usually have a minimum required balance and sometimes limits on the size and frequency of withdrawals, but they also pay better interest on your savings than regular savings accounts. --The idea behind M1 and M2 is liquidity. They are measures of the money people have available to spend. When something is highly liquid, that means it can be quickly converted to cash and used for purchases. If something has low liquidity, then it is harder to sell it for a fair value at any time.Cash and coins are the most liquid, as they are already cash and available to spend right away. It’s also very easy to spend money in your checking account or savings account. These days, most banks give you a debit card to spend directly from the accounts. In the old days you had to write and cash a check. But what makes this slightly less liquid than cash is that the bank could freeze your card and make claiming the full value of what is in your account a little more difficult. Below that are money market accounts. These accounts are usually offered by banks or other financial institutions, and they impose certain requirements like maintaining a minimum balance in exchange for paying you a higher interest rate on your savings. Money in these accounts is safe, but the requirements might make accessing it right away to spend a little more difficult. Similar to that are certificates of deposit, where a bank will pay you a fixed interest rate if you agree to deposit your money for a set amount of time like 1 year or 10 years. The longer you agree to keep your money deposited, the higher the interest rate paid usually is. Money placed into CDs is also very safe, but the delay in getting it back makes it less liquid. M1 includes only the highly liquid assets: cash itself and the stuff in regular bank accounts. M2 includes those as well, but adds some things that are very liquid, like small money market accounts – which have weaker limitations – and short-term certificates of deposit. As you might guess, there is also an M3 and an M4 and so on, which allow for longer time-periods on those CDs and other deposits. But if you went around asking people how much money they had, they would probably want to include any money they have in stocks and bonds, but these are not included our measures of the money supply. It’s pretty easy to sell your stocks or bonds and get some cash pretty quickly, so they may seem like pretty liquid assets. The problem is that the value of these assets is not set, it can fluctuate. When you put your money in a CD, you know exactly how much will be there in six months, because the interest rate is known and there is no risk of losing your money. That isn’t the case with the stock market, so those balances don’t get included. The same goes for any other assets people might be holding, like cryptocurrency, NFTs, or just boring regular real-life artwork which is often used as a store of value. --Here is a look at M1 and M2 since 1980, going until 2021. You can see that M2 is unsurprisingly higher than M1, since it includes the same things as M1 plus some other stuff. But in May of 2020 there is a dramatic change in these measures as we can see if we extend our graph beyond that point. This has nothing to do with the pandemic or money creation. If you look in older textbooks, you will see that Savings Accounts were not part of M1 before May of 2020, but they were still part of M2. Savings accounts used to be more like money market accounts, with minimum balance requirements and strict limits on withdrawals, but these days most banks will give you a separate debit card so you can freely spend money right out of your savings account. The degree of liquidity has changed, and so the powers that be decided it made more sense to start including those savings accounts in M1. One way to think about these two measures of the money supply is that M1 is a measure of how much money people have available to spend right now, today. And M2 is a measure of how much money they could put together if you gave them a little time to get their short-term deposits back from CDs and money market accounts. So, the next time a five-year-old asks you how much money there is, you can put them to sleep explaining how that depends on if you go with the monetary base, M1, or M2.

Practice Questions

1. Coach Wade has $2,200 in cash, another $12,500 in his checking account, a brokerage account with $18,900 invested in an S&P 500 Index Fund, and a retail money market account with $32,000 in it. How much is Coach contributing to M1? What about M2?

Reveal the Answer

M1 includes cash, coins, checking accounts, and savings accounts.

M2 includes cash, coins, checking accounts, savings accounts, certificates of deposit (aka 'time deposits') and money market accounts.

So, for M1, we include the $2,200 in cash and the $12,500 in checking. That means M1 is $14,700 for Coach.

For M2, we include that same $14,700, but add the $32,000 in the money market account. That means M2 is $46,700 for Coach.

The money in the S&P500 Index Fund is invested in stocks, which do not count in either measure of the money supply.

2. Coach has decided to move $2,500 from his checking account into his money market account. How have M1 and M2 changed?

Reveal the Answer

After moving the money, Coach now has:

$2,200 in cash
$10,000 in checking
$18,900 in the brokerage account
$34,500 in the money market account

For M1, we include the $2,200 in cash and the $10,000 in checking. That means M1 is $12,200. So, M1 is down $2,500.

For M2, we include that same $12,200, but add the $34,500 in the money market account. That means M2 is $46,700. So, M2 is unchanged.

Watch out for the trap of thinking of M1 and M2 as opposites, where any change in one of them has the opposite change in the other. M1 sits inside of M2 like a room in a house. Take money from one room to another and M1 changes, but M2 - the money in the house - stays the same.

A Monetary History of the United States

John Maynard Keynes had suggested that market economies were inherently unstable. Driven by animal spirits, people could keep an economy at less than full employment with low aggregate demand. According to early Keynesian economists, the Great Depression was the result of a sharp fall in investment that came in the wake of the stock market crash and subsequent banking panics.

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In 1963, the economists Milton Friedman and Anna Schwartz released a voluminous text that was the result of years of research smartly called A Monetary History of the United States, 1867-1960. The book set out to investigate the role the money supply played in the economy, and Friedman and Schwartz had to cobbled together what data they could to see if Keynes’ belief that money was not neutral held any weight. Milton Friedman was awarded the Nobel Prize in Economics in large part for this work, though Anna Schwartz strangely was not, despite the fact that Friedman had joined Shwartz’s research team for it and not the other way around. Their work is famous for propagating a few important, now widely held claims, about the role of the money supply in the economy. First is that inflation is always and everywhere a monetary phenomenon. By this they meant that inflation was always the result of too much money circulating in the economy, and deflation was always the result of too little money. Proper management of the money supply by the Federal Reserve should then always be able to manage the price level. --In addition to these claims about inflation, Friedman and Schwartz also investigated the role of the money supply in the business cycle. The classical economists had assumed the money supply would have no role in the business cycle, but Keynes had overturned the theory of money neutrality and claimed that the money supply was central to recessions because prices and wages were sticky. A lower money supply would mean lower aggregate demand and an economic downturn. As it turns out, Friedman and Schwartz could only find six periods in their history where the money supply contracted outright. They coincided with the six most severe economic downturns over that time period. The Panic of 1873, the Panic of 1893, the Panic of 1907, the Post-War Dip after World War I, the Great Depression, and the second downturn that happened in the midst of the recovery from the Depression. But what was incredible is that these contractions in the money supply did not seem to be symptoms of the recession, but rather the causes of them. --Let’s start with the Panic of 1873. Was it the frenzy of bank runs contracting the supply of credit that led to the reduction in the money supply? No. The contraction in the money supply pre-dates the panic, when it contracted by 4.6% as the U.S. demonetized silver and returned to a strict gold standard and – you’ll remember – kicked off the Long Depression which saw the rise of the Free Silver movement devoted to undoing this change. --But that same movement would worsen the Long Depression with the Panic of 1893. As William Jennings Bryan was gaining steam, people who held a lot of gold were worried that the U.S. would indeed monetize silver again by issuing paper money backed by silver. With an increase in the money supply looming on the horizon, investors expected interest rates to fall, which made foreign investments with relatively higher interest rates more attractive. These investors moved tons of their gold overseas to protect it from the uncertainty, and in doing so they caused a 5.8% drop in the money supply which remained exclusively on the gold standard. --Well surely the Panic of 1907 was its own cause of the contraction in the money supply. We talked about how Otto Heinze attempted that shady maneuver to manipulate the price of United Copper and failed so spectacularly that he took down the Knickerbocker Trust Company and set off a wave of bank runs. Yes and no. Freidman and Schwartz found that the reduction in the money supply was due to an increase in reserve ratios banks set for themselves in response to the panic. But had they maintained their reserve ratios and continued lending, the money supply would not have shrunk. --After World War I the U.S. saw a relatively brief recession as the economy transitioned to peace time. But in the years that followed the U.S. experienced higher than normal inflation, and the Fed responded by sharply increasing their discount rate from 4.75% to 7%, which was the highest it had ever charged to that time. The policy was successful in stopping the inflation, but unfortunately that was because it was so successful in plunging the economy into a recession.--Then there was the Great Depression, which came in two waves. The initial wave of recession from 1929 to 1933, and then the second wave – or double dip – which happened in 1937 and 1938. We know the story here, right? The stock market crashed causing a panic, and, in the uncertainty, there was a wave of bank failures which didn’t end until FDR’s banking holiday and New Deal programs. But when FDR raised taxes for Social Security, the economy sank again. Friedman and Schwartz disagree. They found a singular culprit. It was all the way back in 1928 when the Federal Reserve, offput by the excess and cultural change of the 1920s, decided to tighten monetary policy and raise interest rates, causing the economy to slow. That brought about the downturn in the summer of 1929 that made investors pause and the stock market to plunge. That all might have been ok – a correction of a market bubble – but then in 1931 the Federal Reserve raised interest rates in order to attract more gold into their reserves to maintain the gold standard after Britain moved off it and many assumed the US would too. But we didn’t. Instead, we forced the Fed into an impossible situation where they had to choose between their legal obligation to the gold standard and the collapse of the entire economy. But leave it to them to botch the job even worse than they had to. After pressure from Hoover and Congress, the Fed did try to alleviate the problems by pushing interest rates down with open market operations. But they pulled the plug on them far too soon, and allowed them to rise again just months later, sealing the fate of the economy. All told, the money supply shrank by 25% between 1929 and 1933 due to these policies. So, what about the double dip? Does the Keynesian explanation of higher taxes explain what happened there? Friedman and Schwartz say no. They pin the blame on – once again – the Federal Reserve, which in 1937, for reasons passing all understanding, they doubled the required reserve ratio, shrinking the money supply again. --In their landmark book, Milton Friedman and Anna Schwartz had poured through a mountain of historical records and in them found the bedrock of a new understanding of the economy. Where Keynes had seen animal spirits, they had found bad monetary policy. The Long Depression owed itself to the Gold Standard and the uncertainty surrounding it. The Panic of 1907 was driven by the lack of a good central bank, but the Post-War Dip was driven by the mistakes made by the newly formed central bank. And the perfect storm that brought on the Great Depression was both the Gold Standard, which entangled the world together, and sheer incompetence on the part of the Federal Reserve. So conclusive were their findings, that most of the economics profession today agrees that the Great Depression was only ‘Great’ because of the mismanagement of the Federal Reserve. --At a conference in 2002, one of the members of the Fed’s Board of Governors, Ben Bernanke, gave a talk in which both Milton Friedman and Anna Schwartz were in attendance. Bernanke closed with the following: “Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression, you're right. We did it. We're very sorry. But thanks to you, we won't do it again.”As fate would have it, Ben Bernanke would later be appointed Chairman of the Federal Reserve, where he would face the greatest economic crisis the U.S. had seen since the Great Depression.

The Monetarist School

Friedman and Schwartz had uncovered strong evidence that the money supply played a decisive role in the business cycle. Keynes had been right, money was not neutral. But in placing the blame for recessions on contractions in the money supply, they were drawing different conclusions than Keynes about how to properly manage the business cycle. Where Keynes favored Fiscal Policy, the Monetarists would favor Monetary Policy.

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In the 1970s, the economists Joan and Richard Sweeney belonged to the Capital Hill Babysitting Co-op in Washington, D.C. The co-op had about 150 families in it each with kids. Members of the co-op who needed a babysitter could turn to the other members to watch their kids. By joining the co-op, you could get free babysitting when you needed it in exchange for doing a little babysitting yourself. Since everyone had kids, watching a few more for a night wasn’t too hard, and so it worked out to be a good deal for everyone involved. To make sure that everyone was pulling their weight and not mooching of the system, the co-op printed off coupons which you got when you joined. Each coupon was good for ½ hour of babysitting. So, if you needed a babysitter for three hours, you would have to pay another family in the co-op six of the coupons. And you could earn the coupons by babysitting for others. It was a simple monetary system which facilitated the babysitting exchange so that it was fair. There were some administrative duties, however, and some co-op members had to do some extra work like making the coupons, helping new members, and maintaining a list of members and distributing it so people knew who to call and so on. Wanting to keep everything free from real money, those who did this extra work were paid in coupons. But to ensure the system was fair, the coupons the administrators got came from annual fees every family had to pay in the form of coupons. It was like a little government that levied a small tax in order to pay for the administration of the whole system. Very clever, and it worked great. Except for one small snafu. For a couple of years, each member paid about 28 coupons per year in these fees for a total of 4200 coupons. But the people working in administrative positions were only paid about 3800 coupons. The other 400 coupons were stuffed away in a box and essentially taken out of circulation. The money supply was shrinking. --Couples employed a sensible strategy. They would babysit a bunch and build up a stockpile of coupons they could use when they were busy. But as coupons disappeared, building up those reserves became harder. There was suddenly less coupons coming in than they needed to maintain their stockpile. Worried that they wouldn’t have enough coupons for a potential emergency, everyone was staying home. I mean, think about it. If the co-op lost 400 coupons every year, it was just impossible for everyone to maintain their stockpiles. They had to be diminished, and that psychologically worried people enough that they stopped asking other members to babysit for them. The co-op had fallen into a recession where no one could get work. Their economy had screeched to a halt. The co-op, being in Washington D.C., was mostly lawyers who wanted to start imposing rules about using a minimum number of coupons each month. Regulation was their answer. But Joan and Richard Sweeney knew better. As economists, they understood the problem here was a shrinking money supply and fixed prices. Since each coupon was worth a fixed ½ hour of babysitting, people were resistant to changing their value and say offering just 1 coupon for a full hour. The answer the co-op was looking for was that they just needed to print off a bunch of these fake coupons and give them to everyone. Eventually, after their requirements on members didn’t work, the lawyers listened to the economists and printed more coupons, and soon, the co-op was back to normal. --This little parable illuminates the finding of Milton Friedman and Anna Schwartz. People have what we call liquidity preferences, or demand for money. Actually, it was John Maynard Keynes who identified the importance of this liquidity preference. When we have plenty of money, we feel confident in spending it. We are more willing to remodel our home, or go on vacation, or just do simple things like go out to eat a little more.--But if the money supply shrinks, and the circular flow of income doesn’t have enough cash to ensure everyone is able to meet their liquidity preference, then people start to pull back on their spending. They cancel their vacations, put off the remodel, and stay in more, just like the babysitting co-op. In the orthodox Keynesian school, recessions were caused by a change in people sentiments. When people get spooked by economic uncertainty, they are driven by animal spirits to pull back on spending, and the paradox of thrift makes their fear a self-fulling prophesy. But in this new Monetarist perspective, people’s sentiments aren’t so fragile. They aren’t being spooked by the news; they are seeing their actual account balances shrink because there isn’t enough money circulating in the economy. Its contractions in the money supply, not animal spirits, that cause these recessions. --Keynes emphasized fiscal policies like government spending and taxes as a way to manage the business cycle and keep the economy at full employment. But the monetarist view emphasized monetary policies instead. When the economy is booming, the central bank should pull back on the money supply and raise interest rates to keep inflation at bay. But if the economy falls into a recession, then it’s time to increase the money supply and reduce interest rates. That should boost aggregate demand and bring the economy back to full employment. --To better understand the difference here, let’s compare the two programs. Fiscal policy is something the government – Congress and the President – are in control of. During a recession they cut taxes and increase government spending. When resources are idle, as they are in a recession, that additional spending gets magnified by the expenditure multiplier, which boosts aggregate demand and brings the economy back to full employment. Monetary policy is something the central bank – in the U.S. it’s the Federal Reserve – is in control of. During a recession, they use open market operations to purchase government securities like bonds from banks, giving them excess reserves and increasing the supply of loanable funds. That lowers interest rates which boosts investment spending and consumption spending too, which pushes up aggregate demand and restores the economy to full employment. Both Keynesians and Monetarists are on the same page when it comes to these policies and their effects. But since Keynesians see investment spending as too unpredictable to rely on, and recessions as the result of the paradox of thrift, fiscal policy is their preferred tool and the one they believe will be the most effective. Monetarists, on the other hand, see fluctuations in the money supply as the root cause of recessions, and that good monetary policy is not only the best way out of a recession but also the best way to avoid them. --Milton Friedman himself took a stronger stance on monetary policy. His research had shown that the Gold Standard was too strict and made the money supply too volatile. But he also found that the Federal Reserve can be so badly mismanaged that it can plunge the economy into a Great Depression. He proposed the K-Percent rule, which says the supply of money should grow at a fixed rate each year, irrespective of the business cycle. Friedman was quite literally suggesting that we let a computer run monetary policy for us. A computer wouldn’t be prone to human biases and prejudice. It could just increase the money supply by a fixed rate every year and keep the money supply growing steadily. Friedman’s support for this proposition was the result of further research he did which connected our short-run aggregate supply to the long-run, which we will talk about next. But when you consider the recent rise in cryptocurrencies, many of which have hard-coded something like the k-percent rule into them, you start to see why Friedman was a man ahead of his time.

The Money Illusion

Most people don't like inflation because it ends up being a kind of pay cut. You are still getting the same salary, but now prices are higher and you can afford less. In the lingo of economists, your real wage has gone down. But how can businesses get away with this? Why doesn't a competitor come in a try to lure you over with slightly higher pay, which inflation makes easy for them to afford? For that matter, why don't people go looking for these salary increases!? The answer seems to be that people are focused on their nominal wage, and not their real wage.

Open Video Transcript

As we have said before, inflation should be a tide that lifts all boats, but in practice it usually lifts the prices at the store well before it lifts the wages and salaries earned by workers. The short run is essentially the time it takes changes in the price level to go from showing up at the store to showing up in your paycheck. But this disconnect between inflation and wages requires a sort of mass delusion where people ignore – or think there is nothing they can do – about changes in their real wages, or how much they can afford with the money they earn.--The money illusion is what economists call that mass delusion. We are assuming that people are essentially fooled by the level of money income they earn. Tell me, if I gave you a 10% raise, but the prices of everything you pay for, from rent to food to everything else, also went up by 10%, would you consider yourself to be richer? Would you work harder for that raise? The money illusion says yes, you will. Even though you can’t afford any more stuff with your 10% raise, you’ll still work 10% harder for that raise. The money illusion is the theoretical foundation for the Phillips curve, which we examined before. Here I have reconstructed it to get a better sense of what it says about the economy. Within our green band here the economy is healthy and at full employment. But if the economy follows the Phillips curve, with a trade-off between inflation and unemployment, then the Federal Reserve could reduce unemployment by creating some more money and causing more inflation. Higher inflation means lower unemployment, and an overheated economy. Alternatively, if there is a contraction in the money supply, like there was prior to the Great Depression, then the economy might have to deal with deflation, and the Phillips curve tells us that deflation will result in extremely high unemployment. We saw that these predictions match reality, but this theory just didn’t sit well with a lot of economists like Milton Friedman. Why would people suffer from such an irrational mass delusion about their nominal income like this?--Here is an example to illuminate why the money illusion is so frustrating for economists to accept. Let’s say that Jonathan is working for the Rarotonga tribe, and they are paying him a nice salary, but then inflation raises the prices of everything in the economy, meaning that Jonathan can afford less on his same salary. The money illusion suggests that Jonathan won’t do anything about this. He won’t demand a raise or change his labor market decisions as a result of what is essentially a big wage cut. Even more frustrating is that the money illusion assumes that other tribes, like the Aitutaki, won’t be willing to pay Jonathan what he is really worth – the same real wage he was getting before – and wont bother offering Jonathan better pay to lure him over, which would be a good deal for them both. But we’ve said that the short run is the time it takes for these changes in the economy to occur. Eventually, either Rarotonga tribe raises Jonathan’s pay, or he is going to switch to the job that does raise his pay. --But can we really believe that it takes everyone months or even years to make these changes? Do we really think that no one is going to try and capture the profit that can be made by offering wages adjusted for inflation, and that people won’t take these jobs? The theory was in desperate need for a mechanism that connects the short run to the long run. Something that explains why people would be making these systematic mistakes. --In their landmark book, Friedman and Schwartz found that a contraction in the money supply meant doom for the economy. But they also saw that in some more mild recessions, the money supply still went up, but much more slowly than in the previous months and years. Remember, on the Gold Standard the money supply changed mostly on its own, and with changes in reserve ratios. They concluded that the mechanism by which the money supply has an impact on the economy is by defying expectations.--Both workers and firms are operating under uncertainty about future economic conditions. Firms want to be competitive, and they need to offer competitive salaries to attract workers. Workers also want to be paid fairly for the work they do. But who knows what inflation is going to be over the next year or two? We have to make guesses about it, and those guesses are usually going to be wrong. The economists Edmund Phelps and Milton Friedman developed the expectations-augmented Phillips curve, which still shows a short-run trade-off between inflation and unemployment. But it’s not raw inflation that matters. Instead, its whether or not inflation is higher than expected, or lower than expected. If everyone guesses that inflation will be 2% next year, and then inflation really is 2%, then everyone will have made all the proper adjustments for it already, and the economy will rest at full employment. This is in contrast with the original Phillips curve, which would say that any inflation will mean a lower level of unemployment. Here it is only unexpected inflation that matters. If there is more inflation than people expect, that means employers got a good deal, and they will increase hiring. Essentially, they gave everyone 2% raises, but prices went up by more than 2%, giving them higher profits and leading them to increase production. If inflation is anything less than 2%, then these firms will be in a bind. Their costs of labor will be too high, and they will need to lay some people off to make ends meet. --The key, then, is to balance inflation with expectations. The Federal Reserve, with their control over the money supply, has the ability to manipulate the level of inflation. Edmund Phelps and Milton Friedman suggested that people had adaptive expectations. People base their inflation expectations on the recent past. So, a business or a worker planning for the future will predict inflation will stay about the same as it has been in the past year or so. If this is true, then it will be changes in the rate of inflation that will impact the economy. Speed inflation up and you will reduce unemployment. Slow inflation down and you will slow the economy down too. Under adaptive expectations, the Fed can easily manipulate the economy. But some other economists, like John Muth and Robert Lucas, found this explanation as difficult to believe as the money illusion. This was just a different kind of illusion. Instead, they suggested people base their expectations on all available information. If the public is aware that the Federal Reserve has increased their bond purchases and is expanding the money supply, and this isn’t to offset any reduction in government spending or something like that, then why would they be so foolish as to think inflation won’t be higher than before? If it’s easy for people to improve their predictions by just reading a newspaper, why would we think multinational corporations with an entire staff of people employed for the sole purpose of predicting future economic conditions would be getting this so completely wrong? It was a good point, and the devastation it would wreak on the Keynesian framework was only just beginning.

The Cold Fronts are Listening

Those who favored the assumption of Rational Expectations emphasized the importance of "microfoundations" in macroeconomic models. They wanted macroeconomics to be consistent with microeconomics, where people are assumed to be rational. But their campaign of incorporating microeconomic theory into macroeconomics led them to some very different conclusions than those of the Keynesians or Monetarists, and they formed the New Classical school of thought.

Open Video Transcript

The emphasis on expectations was reforming economist’s views on the business cycle. Keynes had said that wages were sticky, and it was nothing but stubbornness that they didn’t change. But the Monetarists had suggested that the stickiness was really due to a mismatch between expected inflation and actual inflation. When the economy is functioning normally and at full employment, competition between firms ensures that labor markets set fair wages for workers and everyone who wants a job, anyone participating in the labor force, will get one. But as time goes on, firms have to make judgements about future inflation so that they can stay competitive. They set their expectations for inflation and make adjustments to their employee's salaries. Again, its competition between firms that drives this. If one firm is giving cost of living raises, other firms need to match in order to attract and retain employees. But let’s say that inflation outpaces those expectations. In this case the firms have cause for celebration. They raised salaries to stay competitive, but it turns out that the raise was smaller than it should have been. Firms are seeing higher revenues due to inflation, but their labor costs are lower than they should be. With a better profit margin, firms opt to strike while the iron is hot and hire a few more workers at these bargain wages and overproduce. This is an economic boom, where the economy burns through resources too quickly. But then we go through another round of the expectations game. Firms reset their expectations and have to adjust salaries to match. Let’s say that this time they overshoot inflation, which ends up being way lower than expected. Now firms are in a panic. Revenues are way down as prices fall (or fail to rise fast enough to meet obligations). To keep the bottom line from plunging into the red, these firms have to reduce their workforce significantly, laying people off because workers are just too expensive due to the oversized raises they gave based on their inflation expectations. Now the economy is in a terrible recession, and it won’t recover until the Fed or other government policy reinflates the economy to support these wages. This is our new Monetarist model of the economy. --But there was disagreement about how firms and everyone else would set their expectations. Early monetarists used adaptive expectations in their economic models. But a new group of economics, who would come to be called the New Classical School thought that this was an absurd assumption, and instead believed that people had rational expectations. It may sound innocuous, but these two assumptions have massively different conclusions about countercyclical policy. --Here is what the proponents of rational expectations found so silly about adaptive expectations. We have this massive organization called the Federal Reserve which has been endowed with incredible powers over the money supply and unlimited ability to control the rate of inflation with a mandate to use those powers to do exactly that. And every time they have a meeting of the Federal Open Market Committee, the Chair of the Fed comes out and tells everyone what they are going to do in a press conference which is covered by every news organization in the country. The assumption of adaptive expectations believes that everyone simply ignores them and chooses to believe inflation will just continue with whatever it was most recently. --Rational expectations doesn’t assume people have magic abilities when it comes to forecasting inflation. This New Classical school suggests that people will almost always get it wrong. But they assume that the people will take into account all the information available. And so, if the Federal Reserve says they are targeting 2% inflation, then people will take that into account. And if the Fed is credible in their claim, meaning that they usually deliver on their promises and hit their targets, as they often do, then inflation will never really differ from expectations. And so monetary policy will be baked into the system. This is both good news and bad news. It means that a transparent Federal Reserve which credibly commits to its inflation target and consistently hits it will be able to keep the economy stable. So long as inflation doesn’t significantly deviate from expectations, things will be fine. But if something unexpected happens, as it will from time to time, the Federal Reserve will be powerless to help the economy. Because anything they do will be taken into account and accommodated for. Only random and unpredictable deviations from expectations will have any real effects on the economy. Money might not be neutral, but monetary policy will be. --The bad news for the Keynesian view did not end there. These new economists also brought expectations into their analysis of consumer behavior. They formed the Permanent Income Hypothesis, which predicts that people will try and smooth out their consumption across their lifetime. There is still a lot of uncertainty in life, but some things are pretty predictable. And people will act in advance of them happening. This idea matches what we see in reality. When people are young, they tend to borrow money for things like school, cars, and houses. But as they get older, their incomes tend to increase, while the spending stays about the same. They start saving a lot more, and eventually they retire, dropping their earnings to zero but living off their savings and keeping consumption about the same. Rational people do this because it’s a very rational thing to do. But this theory is incompatible with Keynesian economics. --To keep things simple, let’s just have income flat like this, and consumption smoothed out across it. During a recession, the Keynesians say the government should cut taxes and increase spending. Both policies are designed to increase people’s incomes, but only temporarily. The permanent income hypothesis says that people will try to smooth this additional income out over their lifetime. So, if a recession strikes and the government sends everyone a stimulus check in the mail, the New Classical economists hypothesized that most would spend a little bit of it, but probably save the rest or use it to pay off some debts. Actual increases in consumption spending will be only a small fraction of the government spending. And it doesn’t stop there. People will see through the government plan. They know the money is coming in today, but down the road they will have to raise taxes to pay off the government debt. Expecting a tax increase that will reduce their income, people will just save the whole thing, and the government stimulus won’t help the economy at all. Rational Expectations suggested that Keynes’ expenditure multiplier was very small, and maybe even equal to one, offering no magnification of government spending at all. --The criticism that so badly undercut the idea that the government or the Federal Reserve was capable of managing the economy can be summed up as, “The cold fronts are listening.” When a weatherman predicts the weather, the clouds don’t conspire to prove him wrong. But when it comes to the economy, the people can see what policies are being implemented, and they can incorporate them into their decisions. Here is another analogy. Suppose government data says the typical American family buys one box of Cheerios each week. The Keynesian view is that the government could start a new program where they buy a box of Cheerios and send it to every household each week, then the typical household will now have two boxes, boosting employment at Cheerios factories. The Lucas Critique, laid down by the Nobel-prize winning economist Robert Lucas, was that the future does not look like the past and people will respond to economic policies in advance. Reading about the new program and expecting a box of Cheerios to come from the government, households will simply reduce their Cheerio purchases by one box per week, and the typical household still gets one box per week in the end. The government can’t boost our overall Cheerio consumption by buying us Cheerios, and they can reduce unemployment that way either. From the Lucas Critique we get the Policy Ineffectiveness Proposition, which argues that economic policy cannot systematically manage aggregate demand, and thereby manage the levels of output and employment in the economy. --Around the same time as the New Classical school of thought was laying out these critiques and propositions, the economy was experiencing a kind of turbulence that defied the suppositions of the Keynesian view. An energy crisis brought about by spikes in oil prices, combined with continued high government spending, embroiled the economy in a bout of high inflation and high unemployment. The short run trade-off between inflation and unemployment predicted by the Keynesian model was broken, and Keynesian theory was on the outs in the economics profession.

Empirical evidence generally comes down on the side of adaptive expectations over rational expectations. But rational expectations still reigns supreme in economic models. Luckily, you don't have to decide. There are robust markets where being right about inflation is profitable, and inflation expectations can be inferred from those prices. This chart assembles several measures together and shows the best wisdom of the time about inflation over the next year!

Quick Quiz

Now is the time to test yourself on these concepts! This quick quiz is a great way to see what has clicked and what needs more attention. It is also a good time to reach out to your instructor with questions.

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Example Question
Suppose that the level of unemployment in the economy is determined by the follow equation:

U = 7.33 - 1.92*(i - i^e)

Where U is the unemployment rate, i is the actual inflation rate, and i^e is the expected inflation rate. All variables are entered in percentage form (e.g. if inflation is 30.57%, you plug in 30.57 for i, not 0.3057).

Last year, the inflation rate was 7.28%, and people have adaptive expectations. What does the inflation rate need to be this year in order for the unemployment rate to be 2.3%?

Note: Everything is already in percentage form. You do not need to multiply or divide by 100 at any point. Enter in your answer as it is calculated in the equation.

Round your final answer to two decimal places.

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