While I’m only 275 pages into Ed Nelson’s big 2 volume set entitled “Milton Friedman & Economic Debate in the United States”, I can already say that it’s one of my favorite books on macroeconomics.
One issue that has frequently puzzled me is how to interpret causality in the Phillips Curve relationship. I have always interpreted Friedman’s natural rate model as one where causality went from inflation to output. More specifically, if inflation is higher than expected, then unemployment will be lower than the natural rate, and vice versa (perhaps due to sticky nominal wages.)
Keynesians usually seem to interpret causality in the opposite direction, low unemployment causes high inflation, and vice versa. And today, that seems to be the most widely accepted interpretation. Nelson (p. 273) quotes Friedman offering an interpretation that is consistent with my view:
There was, however, a crucial difference between Fisher’s analysis and Phillips’s, between the truth of 1926 and the error of 1958, which had to do with the direction of causation. Fisher took the rate of change of prices to be the independent variable that set the process going.
But Nelson also cites other statements by Friedman that are consistent with the Keynesian interpretation. He then suggests:
Friedman was also clear that both inflation and unemployment were endogenous variables. That being the case, neither a story based on causation from unemployment to inflation nor a story based on causation from inflation to unemployment can be accepted as a comprehensive description of the Phillips Curve relationship.
You probably know what I’m going to say. What’s really going on is that both inflation and unemployment are affected by NGDP shocks. When NGDP rises faster than expected, it increases inflation and reduces unemployment. When NGDP rises slower than expected, inflation tends to fall and unemployment rises. But what does Nelson say? How does he reconcile various statements by Friedman that seem inconsistent?
The answer offered here is that Friedman’s perspective was that, although inflation and output were jointly determined, the former variable could in large measure be usefully regarded as the driver of the relationship because inflation is a nominal variable and hence ultimately policy determined. Fluctuations in output (in relation to potential) would not occur if the private sector’s expectations of nominal variables corresponded continuously to the actual paths.
I really like this explanation. In Chapter 1 of my book coming out in July, I discuss the tricky issue of causality in macroeconomics. In the end, I conclude that statements about causal relationships should be judged on their usefulness. Thus it’s useful to say that monetary policy caused the Great Recession if another plausible setting of monetary policy instruments would have prevented the Great Recession, but not otherwise.
While Friedman is my favorite macroeconomist, I don’t believe that he got everything right. Like most people of his generation, he focused a lot of attention on inflation. And yet in many cases, his analysis makes more sense if you substitute NGDP growth for inflation. Thus his claim that a slowdown in inflation almost always results in higher unemployment would be more accurate if applied to a slowdown in NGDP growth. After all, inflation can slow due to a positive supply shock.
I’ve recently discovered another Ed Nelson paper on whether it makes sense to think in terms of “nominal shocks”, and will more to say on this issue in a future post.
PS. Friedman’s quote is referring to a 1926 paper by Fisher that first developed the so-called “Phillips Curve”. It was rediscovered by Phillips in 1958, who gave it a Keynesian interpretation. Both Friedman and I prefer Fisher’s interpretation.