Chapter19 TheChicagoSchool TheNewClassicism OVERVIEWOFTHECHICAGOSCHOOLMILTONFRIEDMANROBERTE LUCASJR GARYS BECKER TheHistoricalBackgroundoftheChicagoSchoolMajorTenetsoftheChicagoSchoolWhomDidtheChicagoSchoolBenefitorSeektoBenefit HowWastheChicagoSchoolValid Useful orCorrectinItsTime WhichTenetsoftheChicagoSchoolBecameLastingContributions 1 OVERVIEWOFTHECHICAGOSCHOOL TheHistoricalBackgroundoftheChicagoSchool ManyoftheimportantdevelopmentsineconomicthoughtsincethetimeofMarshallstimulated oratleastrationalized greatergovernmentinvolvementintheeconomy MembersoftheChicagoschoolopposedthisentirelineofreasoning MajorTenetsoftheChicagoSchool ThemainprinciplesandcharacteristicsoftheChicagoschoolmaybesummarizedasfollows 1 Optimizingbehavior 2 Observedpricesandwagesingeneraltendtobegoodapproximationsoftheirlong runcompetitiveones 3 Mathematicalorientation 4 RejectionofKeynesianism 5 Limitedgovernment WhomDidtheChicagoSchoolBenefitorSeektoBenefit ManycorporateinterestshavebenefitedfromthebroaderacceptanceofChicagoviews Ontheotherhand groupsandindividualswhorelyongovernmentforsubsidy employment regulation orspeciallegislationstandtolosebythepoliticalacceptanceofChicagoschoolpolicies WhichTenetsoftheChicagoSchoolBecameLastingContributions Forexample themajortextbooksonprinciplesofeconomicsallhavechaptersonthenewclassicalmacroeconomicperspective includingdiscussionsofanaturalrateofunemployment rationalexpectations along runverticalPhillipscurve andshort runversuslong runaggregatesupply TheChicagotheoriesofhumancapital householdproduction jobsearch anddiscriminationallarediscussedwithintext booksoncontemporarylaboreconomics ConsumptionFunctionMonetaryTheoryEconomicLiberalism 2 MILTONFRIEDMAN ConsumptionFunction AccordingtoFriedman ahousehold sconsumptionisdeterminedbypermanentincomeratherthancurrentincome wherepermanentincomeisdefinedastheaverageincomethatpeopleexpecttoreceiveoveraperiodofyears consumptiondoesnotrespondtoeverychangeinincomecausedbychangesininvestmentorgovernmentspending itrespondsonlytochangesinincomethatpeopleviewtobepermanentandlong lasting MonetaryTheory Thedemandformoney Therearethreemajordeterminantsoftheamountofmoneyhouseholdsandenterpriseswilldesiretoholdatanygiventime 1 Totalwealth 2 Costofholdingmoney 3 Preferences AccordingtoFriedman thedemandformoneyisrelativelystableintheshortrun Themodernquantitytheoryofmoney Anincreaseinthesupplyofmoneywillleavepeopleholdingcashbalancesinexcessofamountstheywant Theywillattempttoridthemselvesoftheseexcesstransactionassets whichwilldriveupthedemandforgoodsandservicesandincreaseoutput prices orsomecombinationofeach Asthepricelevelrises thedemandformoneyincreases Eventually equilibriumbetweenthequantityofmoneysuppliedanddemandedisrestored butatahigherpricelevel ThecauseoftheGreatDepression FriedmanandSchwartzreachedthecontroversialconclusionthatmonetarypolicywaslargelyresponsibleforcausingtheGreatDepressionofthe1930s Later FriedmanexpressedhispositionthattheGreatContractionistragictestimonytothepowerofmonetarypolicy notasKeynesandsomanyofhiscontemporariesbelieved evidenceofimpotence Thelong runverticalPhillipscurve Friedmansaidthereisasimilardistinctionbetweentheactualandnaturalratesofunemployment Thenaturalrateofunemployment saidFriedman istheonethatwilloccurwhentheactualrateofinflationandtheexpectedrateofinflationareequal Figure19 1Friedman sLong RunVerticalPhillipsCurve Themonetaryrule TheFedshouldabandonitsuseofdiscretionarymonetarypolicyandadheretothemonetaryrule increasethemoneysupplyannuallyatasteadyrateroughlycorrespondingtothelong runrateofgrowthofcapacity Therearefourreasonssucharuleisneeded 1 ThepastperformanceoftheFed 2 Limitationsofeconomicknowledge 3 Confidence 4 NeutralizationoftheFed EconomicLiberalism Friedmandescribedhimselfasanineteenth centuryliberal Hewasreferring ofcourse totheeconomicliberalismthatweassociatewiththeclassicaleconomistswhoemphasizedeconomicfreedom Thus overtheyearsheadvocatedaseriesofreformsthatwouldplacelessrelianceongovernmentandmorerelianceonthemarket Themarketsystemprotectsnotonlyeconomicfreedom saidFriedman butalsopoliticalfreedom RationalExpectationsLucas sAggregateSupplyAnalysisEvaluation 3 ROBERTE LUCASJR LucasgoesbeyondFriedman sanalysis sayingthateconomicagentsformrationalexpectationsaboutfutureoutcomesofcurrentstabilizationpolicy Lucassaidthatmarketparticipantsreflectontheirpasterrors useandprocessallavailableinformation andsucceedineliminatingregularitiesinerrorsinpredictingfuturepricelevelchanges RationalExpectations Figure19 2Lucas sNewClassicalMacroeconomics Lucas sAggregateSupplyAnalysis Lucas sanalysisdistinguishedbetweenshort runandlong runaggregatesupply Inthenewclassicalmodelrepresentedbythefigures anunanticipatedchangeinaggregatedemanddoesaffectthelevelofrealoutput butonlytempora rily Incontrast ananticipatedchangeinaggregatedemandhasnoeffectonrealoutputandemployment Evaluation Lucashas ineffect extendedthemicro economictheoriesofperfectcompetition rationalbehavior andWalrasianequilibriumtomacroeconomics