Friedman, Lucas, and market clearing

In retrospect, Friedman's 1967 Presidential Address to the American Economic Association (Friedman, 1968) was the opening shot of the new classical macroeconomics, the precursor of Lucas's ‘misperceptions’ explanation of Phillips curve observations and of the ‘policy ineffectiveness proposition’. Like Lucas (1973) and other new classicals, Friedman deploys ancient classical money-is-a-veil doctrine to argue that only real prices and real wages can determine real quantities of production and employment. Apparent relations between money prices and real quantities, like the Phillips curve, are bound to be ephemeral, especially if policymakers try to exploit them. The Friedman–Lucas doctrine is that the economy behaves as if markets were determining real prices all the time. Those prices are the arguments in supply and demand functions, and equalities of demand and supply shape the path of the economy.

The natural rate, according to Friedman, is ‘the level that would be ground out by the Walrasian system of general equilibrium equations’ (1968, p. 8). The sentence continues with the proviso that ‘imbedded’ in these equations are ‘market imperfections, stochastic variability in demands and supplies, the cost of gathering information about job vacancies and labour availabilities, the cost of mobility, and so on, phenomena that no one knows how to imbed in them’. After this gesture Friedman forgets about these awkward non-Walrasian phenomena and applies classical doctrine unconditionally.

How do deviations from the natural rate occur? There are two possible answers, not necessarily exclusive, new classical and Keynesian.