TheHistoryofthePhillipsCurve: ConsensusandBifurcation

RobertJ.Gordon NorthwesternUniversity,NBER,andCEPR Thisversion,March7,2009,fordistribution PriortosubmissionasaNBERWorkingPaper

Thispaperwaswrittenontheoccasionofthe50thanniversaryofPhillips originalarticle.AnearlierversionwasgivenastheA.W.H.PhillipsInvitedLectureat theAustralasianMeetingsoftheEconometricSocietyinWellington,NewZealand,on July9,2008.NeilSarkarwastheexemplaryresearchassistantontheempiricalsection ofthispaper,andLucasZalduendohelpedtopreparethemanuscriptforpublication.I amgratefultoBobBuckleforsuggestingthetopicandtoDavidHendry,Giorgio Primiceri,andparticipantsintheNorthwesternmacroworkshopforhelpfulcomments.

TheHistoryofthePhillipsCurve: ConsensusandBifurcation ABSTRACT

TheearlyhistoryofthePhillipsCurvethrough1975iswellknown,includingthe christeningofthetermbySamuelsonSolow,theintroductionoflongtermneutralityby Friedman, Lucas, and Phelps, and the apparent wreckage of the Phillips Curve evidentinthepositivecorrelationbetweeninflationandunemploymentinthe1970s. Lesswellunderstoodisthepost1975forkintheroad.TheLeftForkdeveloped a theory of policy responses to supply shocks in the context of price stickiness in the nonshocked sector. Its econometric implementation interacts aggregate demand and supply shocks with longrun neutrality and backwardlooking inertia. The Right Fork approachincludestheworkofKydland,Prescott,Sargent,andthecreatorsoftheNew KeynesianPhillipsCurve(NKPC).Itemphasizesforwardlookingexpectationsthatcan jumpinresponsetoanticipatedpolicychanges.Theleftforkapproachisbettersuited to understand the postwar US inflation process, while the rightfork approach is essentialforunderstandingtheendsofhyperinflationsandthebehaviorofinflationin economieslikeArgentinawithunstablemacroeconomicenvironments. RobertJ.Gordon StanleyG.HarrisProfessorintheSocialSciences DepartmentofEconomics,NorthwesternUniversity EvanstonIL60208 rjg@northwestern.edu http://facultyweb.at.northwestern.edu/economics/gordon

 TableofContents

1. 2. Introduction ....................................................................................................................................... 1 ChangingInterpretationsofthePhillipsCurve,195875 .......................................................... 3 2.1ThePhillipsCurveisBorn:PhillipsandSamuelsonSolow............................................ 3 2.2AspectsofPhillipsCurveEconomicsinthe1960s ............................................................ 7 2.3TheNaturalRateRevolution ................................................................................................ 8 2.4RationalExpectationsandthePolicyIneffectivenessProposition ............................ 10 2.5RejectionoftheEmpiricalCaseAgainstMonetaryNeutrality ...................................... 11 Post1975LeftForkintheRoad:TheDynamicDemandSupplyModelwithInertia...... 13 3.1TheResurrectionofthePC ................................................................................................. 15 3.2EconometricImplementationoftheMainstreamModel................................................ 17 3.3EmpiricalResults:StrengthsandWeaknesses ................................................................ 20 ThePost1975RightForkintheRoad:JumpingandForwardLooking PolicyResponsiveExpectations................................................................................................... 22 4.1ThePolicyGame................................................................................................................... 22 4.2TheNewKeynesianPhillipsCurve(NKPC) ................................................................... 23 4.3TheChallengeofPersistence .............................................................................................. 26 4.4SubtletiesintheInterpretationoftheHybridNKPC.................................................. 27 4.5ConstraintsontheFormationofExpectations ................................................................. 28 4.6WhichModelAppliestoWhichEpisodes? ...................................................................... 29 TheNewKeynesianandTrianglePhillipsCurves:Specification,Estimates, andSimulations .............................................................................................................................. 31 5.1TheNKPCModel ................................................................................................................. 31 5.2TheTriangleModelofInflationandtheRoleofDemandandSupplyShocks ........... 32 5.3EstimatingtheTVNAIRU .................................................................................................. 34 5.4RobertsNKPCvs.Triangle:CoefficientsandSimulationPerformance ...................... 35 5.5HasthePCSlopeBecomeFlatter? ..................................................................................... 37 5.6HastheImpactofSupplyShocksBecomeLessImportant?........................................... 38 Conclusion........................................................................................................................................ 39 Appendix:TheTranslationMatrixbetweentheRoberts/NKPCandTriangle Specifications................................................................................................................................... 42

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1.

Introduction

ThehistoryofthePhillipsCurve(hereafterPC)hasevolvedintwophases, beforeandafter1975,withawidespreadconsensusaboutthepre1975evolution,which iswellunderstood.Bifurcationbeginsin1975,whenthePCliteraturesplitdowntwo forksoftheroad,withlittlecommunicationorinteractionbetweenthetwoforks.The majorcontributionofthispaper,andhencethesourceofbifurcationinitssubtitle,is toexamine,contrast,andtestthecontributionsofthetwopost1975forks. Thepre1975historyisstraightforwardandiscoveredinPart2.Theinitial discoveryofthenegativeinflationunemploymentrelationbyPhillips,popularizedby SamuelsonSolow,wasfollowedbyabriefperiodinwhichpolicymakersassumedthat theycouldexploitthetradeofftoreduceunemploymentatasmallcostofadditional inflation.ThenthenaturalraterevolutionofFriedman,Phelps,andLucasoverturned thepolicyexploitabletradeoffinfavoroflongrunmonetaryneutrality.Thosewhohad implementedtheeconometricversionofthetradeoffPCinthe1960sreeledindisbelief whenSargentdemonstratedthelogicalfailureoftheirtestofneutrality,andfinallywere condemnedtothewreckageofKeynesianeconomicsbyLucasandSargentfollowing thetwistoftheinflationunemploymentcorrelationfromnegativeinthe1960sto positiveinthe1970s.ThearchitectsofneutralityandtheopponentsoftheKeynesian tradeoffemergedtriumphant,withtwomajorcaveatsthattheirownmodelsbasedon informationbarrierswereunconvincing,andthattheircoreresult,thatbusinesscycles weredrivenbymonetaryorpricesurprises,flounderedwithoutsupportingevidence. After1975theevolutionofthePCliteraturesplitintwodirectionswhichhave largelyfailedtorecognizetheotherscontributions.Part3reviewstheleftforkofthe road,therevivalofthePCtradeoffinacoherentandintegrateddynamicaggregate supplyanddemandframeworkthatemergedinthelate1970sineconometrictests,in theoreticalcontributions,andinintermediatemacrotextbooks.Thisapproach,whichI havecalledmainstream,isresolutelyKeynesian,becausetheinflationrateis dominatedbypersistenceandinertiaintheformoflonglagsonpastinflation.An importantdifferencebetweenthemainstreamapproachandotherpost1975 developmentsisthattheroleofpastinflationisnotlimitedtotheformationof expectations,butalsoincludesapurepersistenceeffectduetofixeddurationwageand pricecontracts,andlagsbetweenchangesincrudematerialsandfinalproductprices. Inflationisdislodgedfromitspastinertialvaluesbydemandandsupplyshocks. Theeconometricimplementationofthisapproachissometimescalledthe trianglemodel,reflectingitsthreecornereddependenceondemand,supply,and inertia.Demandisproxiedbytheunemploymentoroutputgap,andexplicitsupply shockvariablesincludechangesintherelativepricesoffood,energy,andimports, changesinthetrendgrowthofproductivity,andtheeffectofNixonerapricecontrols.

Thetriangleapproachexplainsthetwinpeaksofinflationandunemploymentinthe 1970sandearly1980sastheresultofsupplyshocks,andprovidesasymmetricanalysis ofthevalleyoflowinflationandunemploymentinthelate1990s.Itemphasizesthat inflationandunemploymentcanbeeitherpositivelyornegativelycorrelated, dependingonthesourceoftheshocks,thepolicyresponse,andthelengthoflagged responses. Therightforkintheroadisrepresentedbymodelsinwhichexpectationsarenot anchoredinbackwardlookingbehaviorbutcanjumpinresponsetocurrentand anticipatedchangesinpolicy.ReviewedinPart4,importantelementsinthissecond literatureincludepolicycredibility,modelsofthegameplayedbypolicymakersand privateagentsformingexpectations,andtheNewKeynesianPhillipsCurve(NKPC) whichderivesaforwardlookingPCfromalternativetheoriesofpricestickiness.The commonfeatureofthesetheoriesistheabsenceofinertia,theexclusionofanyexplicit treatmentofsupplyshockvariables,theabilityofexpectedinflationtojumpinresponse tonewinformation,andalternativebarrierstoaccurateexpectationformationdueto suchfrictionsasrationalinattention. Whichpost1975approachisright?Modelsinwhichexpectationscanjumpin responsetopolicyareessentialtounderstandingSargents(1982)endsoffourbig inflationsandotherrelativelyrapidinflationsinnationswithahistoryofmonetary instability,e.g.,Argentina.Butthemainstream/triangleapproachisunambiguouslythe righteconometricframeworktounderstandtheevolutionofpostwarU.S.inflation,and theNKPCalternativehasbeenanempiricalfailureasithasbeenappliedtoU.S.data. Part5developsandteststhetriangleeconometricspecificationalongsideone recentlypublishedversionoftheNKPCapproach.Thelattercanbeshowntobenested intheformermodelandtodifferbyexcludingparticularvariablesandlags,andthese differencesareallrejectedbytestsofexclusionrestrictions.Thetrianglemodel outperformstheNKPCvariantbyordersofmagnitude,notonlyinstandardgoodness offitstatistics,butalsoinpostsampledynamicsimulations. ThescopeofthispaperislimitedtotheAmericantheoreticalandempirical literature,withtheexceptionofPhillipsarticleitself.Therearethreemaininterrelated themesinthispaperthathavenotpreviouslyreceivedenoughattention.First,two quitelegitimateresponsesoccurredafter1975tothechaoticstateofthePC.Second, eachresponseisimportantandhelpsusunderstandhowinflationbehaves,albeitin differentenvironments.Third,thetwoapproachesneedtopaymoreattentiontoeach other,andthispaperrepresentsastarttowardthatreconciliation.

2.

ChangingInterpretationsofthePhillipsCurve,195875

WebeginbyreviewingtheevolutionofthePCfromPhillips1958article throughthedevelopmentoftheFriedmanandPhelpsnaturalratehypothesisand Lucasintroductionofrationalexpectations.Beyondthescopeofthispaperare developmentsbefore1958,inparticularthemanyreferencesablysurveyedby Humphrey(1991)datingbacktoHumeinthemideighteenthcenturyregardingthe longrunneutralityandshortrunnonneutralityofmoney.Theonlyexceptiontothe 1958startingcutoffinthispaperisFishers1926articlewhichanticipatesPhillips relationalbeitinterpretsitwiththereversedirectionofcausation. 2.1ThePhillipsCurveisBorn:PhillipsandSamuelsonSolow Theacceptanceofnewideasanddoctrinesisoftenfacilitatediftheyhelpto elucidateanoutstandingempiricalpuzzle.Thustheacceptanceinthelate1960sof Friedmansnaturalratehypothesisoccurredrapidly,becauseithelpedtoexplainthe ongoingaccelerationoftheUSinflationratefarbeyondtherateforecastbyprevious research.Likewise,theacceptanceofthenegativePhillipsCurve(PC)adecadeearlier wasalmostimmediate,sincethePCappearedtoresolveanongoingpuzzleaboutthe interpretationofAmericaninflationinthe1950s. ImplicitinprePhillipsviewsofUSinflationwasareverseLaggregatesupply curve,withthejointofthereverseLatalevelofeconomicactivityoftencalledfull employment.Sustainedincreasesofdemandpullinflationwouldoccurwhenthe economywasoperatingatahigherlevelofactivitythanfullemployment.Butbelow fullemploymenttheinflationratewouldbenearzeroor,atverylowlevelsofactivity, evennegativeasoccurredbetween1929and1933.Theearlyhistoryofthepostwarera wasreassuring,inthatduringtherecessionof1949theinflationratewasnegative(2.0 percentatanannualratefortheGDPdeflatorbetween1948:Q4and1950:Q1).Then inflationreturnedduringthelowunemploymentKoreanwaryears195053toanextent thathadtobesuppressedbypricecontrols. Doubtsemergedbeginningwiththefailureoftheinflationratetodeclinefora singlequarterduringthe195354recession,followedbyitsinexorableriseduring1955 57,despitegrowingovercapacity,slacklabormarkets,slowrealgrowth,andno apparentgreatbuoyancyinoveralldemand(SamuelsonSolow,1960,p.177).No consensusemergedontherightcombinationofdemandpullwithalternativesupply drivenexplanations,variouslynamedcostpush,wagepush,anddemandshift. IntothisfracturedintellectualatmospheretheremarkablePhillips(1958)articlereplaced discontinuousandqualitativedescriptionsbyaquantitativehypothesisbasedonan unusuallylonghistoryofevidence.Since1861therehadbeenaregularnegative relationshipinBritainbetweentheunemploymentrateandthegrowthrateofthe

nominalwagerate.Byimplication,sincetheinflationratewouldbeexpectedtoequal thegrowthrateofwagesminusthelongtermgrowthrateofproductivity,therewasa regularnegativerelationshipbetweentheunemploymentrateandtheinflationrate. Beforeexaminingthedata,Phillipsmakestwoimportanttheoretical observations.First,thenegativerelationshipbetweentheunemploymentrateandthe rateofnominalwagechangeshouldbehighlynonlinear,duetodownwardwage rigiditythatreflectsinturnthereluctanceofworkerstooffertheirservicesatlessthan theprevailingrateswhenthedemandforlaborislowandunemploymentishigh (1958,p.283).Second,therateofchangeofwagesmaydependnotjustonthelevelof unemploymentbutitsrateofchange,andsubsequentlywewilldiscusstheroleofthis rateofchangeeffectinthecontextofU.S.postwarmodelsandoftheinterpretationof theGreatDepression. However,Phillipssurprisinglydebunksathirdpossiblecorrelation,that betweentherateofchangeofwagesandtheretailinflationrate(workingthroughcost oflivingadjustments).Hewasthinkingofaworldinwhichwageratesrepresented fourfifthsoffactorcostsandimportpricestheotheronefifth,andnormallywagerates andimportpriceswouldriseatthesamerate.Onlywhenimportpricesrisefivetimes asfastasproductivitygrowthwouldretailpricesinfluencewagerates.Aninteresting noteisthatPhillipswasalreadythinkingofaworldinwhichdemandshocks(thelevel andchangeofunemployment)andsupplyshocks(therateofchangeofimportprices relativetofinalgoodsprices)bothmatteredindeterminingwageandpricechanges. However,theroleofsupplyshockswasnotfullyintegratedintoPCanalysisuntilthe late1970s. MostofPhillipsarticleconsistsofasetof11graphsdisplayingtherateof changeofthenominalwageontheverticalaxisandtheunemploymentrateonthe horizontalaxis.Graphsareshownforthemajorsubperiods(18611913,191348,and 194857)andforeachbusinesscyclewithinthefirstsubperiod.Theaccompanyingtext providesanexplanationforeachpointthatliesoffthefittedregressionline,whichfor 18611913is w t=0.90+9.64Ut1.39(1) where,asintherestofthispaper,uppercaselettersarelevels,lowercaselettersare ratesofchange,wtistherateofchangeofthenominalwagerateandUtisthe unemploymentrate.Pointsabovethelineareidentifiedasyearsofdeclining unemploymentorrapidlyrisingimportprices,andviceversa.Notethenonlinear formulationandthefactthatneithertherateofchangeeffectnortheimportpriceeffect isexplicitlyincorporatedintotheequation.Aneconometricrepresentationthat includedboththelevelandrateofchangeeffectwassoonprovidedbyLipsey(1960).

 Recallthatequation(1)isestimatedfordataonlyfrom18611913,andthe remainingpost1913dataareplottedagainstthiscurveinordertolocateepisodeswhen theactualdatalieawayfromthecurve.Thechangeinwageratesisremarkablycloseto thepredictionofthe18611913curveexceptforthetwoyears195152whichwere influencedbyrapidincreasesinimportpricesin195051resultingfromthe1949 devaluationofsterling. Phillipsconcludesbytranslatingthefittedcurveforwagechangeintoan unemploymentinflationrelationshipbysubtractinglongtermproductivitygrowth;it appearsthatstablepricesrequireanunemploymentrateofroughly2.5percent. Notably,Phillipsdoesnotconjectureaboutcircumstancesinwhichtheapparentlystable 18611913curvemightshiftupordowninthelongrun.Also,Phillipsdoesnotmention policyimplicationsatall,andthisprovidesthesettinginwhichSamuelsonSolow(1960) christentherelationshipasthePhillipsCurveandexploreitspolicyimplications. SowidelyreadanddiscussedwastheSamuelsonSolowarticlethattheterm PCenteredthelanguageofmacroeconomicsalmostimmediatelyandsoonbecamea lynchpinofthelargescalemacroeconometricmodelswhichwerethefocusofresearch activityinthe1960s.MuchoftheSamuelsonSolowarticleprovidesacritiqueofthe prePhillipshypothesesandthedifficultyofidentifyingthem. Then,turningtothePhillipsevidence,SamuelsonSolowlamenttheabsenceofa similarstudyfortheUSandextractsomeobservationsfromascatterplotofUSdata. First,theUSrelationshipdoesnotworkforthe1930sandthetwoWorldWars.Second, theimpliedzeroinflationrateofunemploymentisabout3percentfortheremaining prewaryears,similartoPhillipsestimateof2.5percent.Third,thereisaclearupward shiftintherelationshipfromtheprewaryearstothe1950s,andthezeroinflation unemploymentrateforthe1950shadrisenfrom3percentto5to6percent. Theystruggletoexplainthepostwarupwardshiftbyinvokingpowerfultrade unionsthatarelessresponsiblethantheirUKcounterparts,and/ortheexpectationof permanentfullemploymentintheUS.Anotherconjectureisthatthecompactsizeof theUKcomparedtotheUSmakeslabormarketsintheformermoreflexible.Onepolicy conclusionisthatanythingthatmakesUSlabormarketsmoreflexiblewillhelptoshift thePCdownwards. SamuelsonSolowhaverightlybeencriticizedforposingalongruninflation unemploymenttradeoffavailableforexploitationbypolicymakers.Astheauthors conclude:Weratherexpectthatthetugofwarofpoliticswillendusupinthenextfew yearssomewhereinbetweentheirselectedpoints.Weshallprobablyhavesomeprice riseandsomeexcessunemployment(SamuelsonSolow,1960,p.193).

 WhileSamuelsonSolowconcludebywarningthatthePCrelationshipcould shiftoverthelongerrun,theirexampleinvolvesalowpressure(i.e.,high unemployment)economyinwhichexpectationsoflowinflationcouldshiftthePC downorcouldaggravatestructuralunemployment,thusshiftingthePCup.They regardeitheroutcomeaspossibleandnotablyfailtoreasonthroughthelongrun implicationsofahighpressureeconomywithitsimplicationsofasteadyincreasein inflationexpectationsandanassociatedsteadyupwardshiftinthePC.Thatinference hadtowaitanothereightyearsforthecontributionsofFriedmanandPhelps. AninterestingsideissueistheantecedentofPhillipsarticlepublishedbyIrving Fisherinanobscurejournalin1926,reprintedandbroughttoawideraudiencein1973. 1 RecallthatSamuelsonSolowlamenttheavailabilityofadetailedstatisticalstudyofthe USanalogoustoPhillipsUKresearch,yetFisherhadalreadyprovidedsuchresearch morethan30yearsearlier. 2 AnotabledifferencewithPhillipsisthatFisherreversesthe directionofcausation,sothatchangesintherateofinflationcausechangesinthelevel oftheunemploymentrate.Fisherexplainsthemechanisminmoderntextbookterms becausecostsofproduction(includinginterest,rent,salaries,andwages)arefixedinthe shortrunbycontractorbycustom,afasterrateofinflationraisesbusinessprofitsand providesanincentivetoraiseoutput.Employmentisthenstimulatedforatimeat least(1973version,p.498).Becauseofthelagofcostsbehindprices,Fisher emphasizesthattherelationshipisbetweenunemploymentandtheinflationrate,not thepricelevel,andthatthepricelevelhasnothingtodowithemployment.Heuses theanalogyofdriving,inwhichittakesmoregasolinepermiletoclimbahillthan descendit,butexactlythesameamounttonavigateahighplateauasonthelowlands. Fishersstatisticalstudyislimitedtomonthlydatafortheyears191525.Whenthe influenceofinflationisrepresentedbyashortdistributedlagoverfivemonths,the correlationcoefficientis90percentbetweentheunemploymentrateandtheshort distributedlagofinflation.AnimportantweaknessoftheFisherstudyisevidentinhis ChartIIbutisnotdiscussedbytheauthor.The90percentcorrelationappliesto191525 buthischartextendsbackto1903.Duringtheperiod190315unemploymentisalmost asvolatileasduring191525butthevarianceofinflationismuchlower,implyingthat therelationshipisnotstableandthatFishersmainresultmaybepickingupthespecial featuresofWorldWarIanditsaftermath(justasPhillipsUKcorrelationisstrong duringWorldWarI).

1. ThearticlewasunearthedbyJacobMincer,andasCoEditoroftheJPEduring197173,Iwas responsibleforthedecisiontoreprintitandgiveitthedramatictitlelistedinthereferencelistof thispaper. 2. Anamusingcommentaryontheresearchtechnologyofthe1920sisFisherscommentthat DuringthelastthreeyearsinparticularIhavehadatleastonecomputerinmyofficealmost constantlyatworkonthisproblem(1926,p.786).

2.2AspectsofPhillipsCurveEconomicsinthe1960s Duringtheearlytomid1960satleastthreeaspectsofthePCemergedthatwould havesubsequentconsequences.First,thePCtradeoffappearedtoprovidepolicymakers withamenuofoptions.ThepolicyadvisorsoftheKennedyandJohnson Administrations,ledbyWalterHellerwithsupportrolesbyRobertSolowandJames Tobin,arguedthatthepreviousRepublicanAdministrationhadchosenapointtoofar southeastalongthePCtradeoff,andthatitwastimetogetthecountrymovingagain bymovingtothenorthwest.HellersgroupconvincedPresidentKennedyto recommendmajorcutsinFederalincometaxes,andthesewereimplementedafterhis deathbytheJohnsonAdministrationintwophasesduring1964and1965.However,in late1963theeconomywasalreadyoperatingatanunemploymentrateof5.5percent thatSamuelsonSolowhadcalculatedwasconsistentwithzeroinflation,andsothe expansionaryKennedyJohnsonfiscalpolicywouldhaveimpliedanaccelerationof inflationevenwithoutthefurtherlooseningofthefiscalfloodgatesduetotheVietnam war. Figure1plotstheUSinflationandunemploymentratesinquarterlydatasince1960, andweshallrefertoitheretoexaminetheperiod196071andthenreturntothesame graphbelowtolinktheevolutionofPCdebatestothepost1971behaviorofinflation andunemployment. 3 Theunemploymentratefellbelow5.5percentin1964and remainedbelow4percentbetween1966and1970.Thesharpaccelerationofinflation fromlessthan2percentin1963to5.5percentin1970isconsistentwithcurrent econometricestimatesofthe1963naturalrateofunemployment(theratethatis consistentwithsteadyinflationratherthanzeroinflation)intherangeof5.5to6.0 percent(seeFigure5below). Asecondaspectofthisperiodwasthedevelopmentofmainframeelectronic computersthatmadeitpracticalforthefirsttimetospecifyandestimatelargescale econometricmodels(abooklengthpolicyanalysisusingtheBrookingsmodelis containedinFrommTaubman,1968).Thespecificationoftheinflationprocessinthese modelsalwaysconsistedofatleasttwoequations.ThePCwasembodiedinanequation fortherateofchangeofthenominalwageinwhichthemainexplanatoryvariableswere theunemploymentrate,sometimesitsrateofchange,somemeasureofexpected inflationbasedonabackwardlookingsetoflags,andperhapsvarioustaxrates. Thentheestimatedchangeinwageswastypicallytranslatedintotheinflation rateinanequationthatrelatedthepriceleveltothewageleveladjustedforthelevelof trendproductivity,socalledtrendunitlaborcost.Thepricelaborcostratioor markupwasallowedtorespondtoameasureofdemand,usuallynotthe

3.InFigure1theinflationrateisthefourquarterchangeinthedeflatorforpersonal consumptionexpenditures.

unemploymentratebutratherameasuremoredirectlyrelatedtotheproductmarket, suchastheratioofunfilledorderstoshipments.Thereducedformofthisapproach impliedthattheinflationratedependedonthelevelandrateofchangeof unemployment,perhapsothermeasuresofdemand,andlaggedinflation.Wereturn belowtotheproblemsencounteredbythesemodelsinconfrontingthedataofthelate 1960sandindealingwiththechallengeoftheFriedmanPhelpsnaturalratehypothesis. Athirdalbeitperipheralfeatureofthiserawastherivalrybetweenthe economicsdepartmentsattheUniversityofChicagoandMITingeneral,andbetween MiltonFriedmanandFrancoModiglianiinparticular.In1965morethan100pagesin theAmericanEconomicReviewweredevotedtoadebatebetweenthemandtheirco authorsovertheissueofwhetheronlymonetarypolicymatteredoronlyfiscalpolicy mattered,adebatethatseemedbizarrewhentheconsensusviewbasedontheISLM modelshowedthatbothmonetaryandfiscalpolicymatteredexceptincertainextreme cases. 4 2.3TheNaturalRateRevolution

PriortothepublicationoftheFriedmanandPhelpsarticles,theoreticalquestions hadbeenraisedaboutthePCframework.Whydidthenominalwageadjustslowly, particularlyinadownwarddirection,andwhatdeterminedthespeedwithwhichit respondedtoinadequatedemand?WhydidthePCliesofartotheright,thatis,why didnominalwagesrisesofastatalowunemploymentrateandwhywassuchahigh unemploymentraterequiredtomaintainzeroinflation?Perhapsmostrelevantin anticipationofFriedmanandPhelps,howcouldthePCbesostableoverhistorywhen thereweresomanyepisodesofhyperinflationsfueledbypermissivemonetaryand fiscalpolicy?Ihavealwaysthoughtthatthedevelopmentofthenaturalratehypothesis atChicago,ratherthanatHarvardorMIT,reflectedthedeepinvolvementofseveral ChicagoeconomistsasadviserstoseveralcountriesinLatinAmerica,wherethelackof correlationbetweeninflationandunemploymentwasobvious. Friedmans(1968)PresidentialAddresscontainedtwosectionsthateachhada mainpoint,closelyinterrelated.First,thecentralbankcouldnotcontrolthenominal interestrateifthatimpliedfasterinflation,becausetheimpliedreductioninthereal interestratewouldaddfueltotheinflationaryfire.Thesecondsectionwasmost importantforthePCdebate,histhenstartlingconclusionthatpolicymakershadno abilitytochooseanyunemploymentrateinthelongrunotherthanthenaturalrateof unemployment,theratewhichwouldbegroundoutbythemicroeconomicstructure oflaborandproductmarkets.Amorepracticalinterpretationofthenaturalratewasthe

4.SpectatorsatthetimecalledtheAERdebatethebattleoftheradiostations,aftertheAMFM initialsoftheprotagonists,AndoModiglianivs.FriedmanMeiselman.

unemploymentrateconsistentwithaccurateinflationexpectations,whichimplieda steadyrateofinflation. Conventionalanalysisbasedonapolicytradeoffignoredtheadjustmentof expectations.Consideraneconomyoperatingatthenaturalrateofunemploymentand withaninitialinflationrateofonepercentthatwasaccuratelyanticipated.Any policymakerattemptingtoreducetheactualunemploymentratebelowthenaturalrate wouldmovetheeconomynorthwestalongtheshortrunPC,pushingthe unemploymentratelowerbuttheactualinflationratehigher.Onceagentsnoticethat theactualinflationrateishigherthantheinitiallyanticipatedrateofonepercent,then expectationswilladjustupwardandshifttheentireshortrunPChigher.Thisprocess willcontinueuntiltheunemploymentraterisesbacktothenaturalrateof unemployment. ThetimingofFriedmansaddresswasimpeccableandevenuncanny.The KennedyJohnsonfiscalexpansion,includingboththetaxcutsandVietnamWar spending,accompaniedbymonetaryaccommodation,hadpushedtheunemployment ratedownfrom5.5percentto3.5percent,andeachyearbetween1963and1969the inflationrateaccelerated,justasFriedmansverbalmodelwouldhavepredicted.The accelerationofinflationbewilderedthelargescaleeconometricians,whohadpreviously estimatedafullemploymentunemploymentrateof4percentandwhoseforecastsof inflationhadbeenexceededbytheactualoutcomeyearafteryear.. Wellawareoftheirownfailuretoforecastthelate1960saccelerationofUS inflation,FriedmansdetractorsattackedtheverbalmodelthatFriedmanusedto motivatethenaturalratehypothesis.Inwhatlaterbecameknownasthefooling model,Friedmanpostulatesemployerswithexpectationsofthepricelevelthatare alwaysaccurate,butworkerswithanexpectedpricelevelthatdoesnotresponduntil afterasubstantiallagtoahigheractualpricelevel.Inabusinessexpansion,firmsraise thewagebutraisethepricelevelbymore,thusreducingtherealwageasneededto providetheincentivetohireadditionalworkers.Butworkersseethehighernominal wageandinterpretitasahigheractualrealwage,becausetheyfailtoadjusttheir expectationofthepricelevel.Friedmansmodelwasattackedasgrosslyimplausible, becauseworkershaveaccesstomonthlyannouncementsoftheCPIandindeedobserve actualpricesastheyshopalmosteveryday.InFriedmansworld,therecouldbeno businesscycle. Phelps(1967,1968)iscreditedwithcodiscoveringthenaturalratehypothesis. IncontrasttoFriedmansdistinctionbetweensmartfirmsanddumbworkers,in Phelpssworldeveryoneisdumb,i.e.,equallyfooled.Bothfirmsandworkersseethe priceriseintheirindustryandproducemore,notrealizingthatthegeneralpricelevel hasrisenintherestoftheeconomy.Phelpsdevelopedonemodelinwhichworkersare isolatedfrominformationabouttherestoftheeconomy.Normallythereisfrictional

unemployment,asworkersregularlyquitonefirmtogolookformorehighlypaidwork atotherfirms.Butinasituationinwhichtheirownfirmraisesthewage,theystaywith thatfirminsteadofquitting.Thustheunemploymentratedecreaseseventhough, withouttheirknowledge,allotherfirmsintheeconomyhaveraisedthewagebythe sameamountatthesametime.Theworkersarefooledintoareductioninfrictional unemployment,andthemacroeconomicdataregisteradeclineintheunemployment rate.Hencethereisashorttermcorrelationbetweentherateofwagechangeandthe unemploymentrate,butthislastsonlyaslongasexpectationsareincorrect. Whetherfirmsorworkersorbotharefooled,thecriticismsdirectedagainstthe FriedmanfoolingmodelapplytoPhelpsaswell.Workersandtheiremployersbuy manygoodsandservicesfrequently;theyobtainnewsontheCPIeverymonth;and perhapsmostimportantifperiodsofhighrealGDPandlowunemploymenthadalways beenaccompaniedbyanincreaseintheaggregatepricelevel,workersandfirmswould learnfromthesepastepisodesandusetheirexperiencetoformexpectationsaccurately. 2.4RationalExpectationsandthePolicyIneffectivenessProposition BoththeFriedmanandPhelpsmodelswerebasedonthetwinassumptionsof continuousmarketclearingandimperfectinformation.Soonthereafterintwo influentialarticlesLucas(1972,1973)extendedtheirmodelbyaddingathird component:rationalexpectations.Workersandfirmsusetheirknowledgeofpast historytoworkouttheimplicationsofanobservedfallorriseinwagesontheoverall wagelevel.Rationalexpectationsimplythaterroneousexpectationserrorsarenot repeated. Lucascollapsedthedistinctionbetweenfirmsandworkersandtreatedall economicagentsasyeomanfarmerswhofacebothidiosyncraticshockstotheirown relativepriceandmacroshockscausedbyfluctuationsinmonetarygrowthandother factors.Theagentsuserationalexpectationstodeducefrompasthistoryhowmuchof anobservedchangeinthelocalpricerepresentsanidiosyncraticshockandhowmuch representsamacroshock.Whenlocalpriceshockshaveahighcorrelationwithmacro shocks,agentsdonotadjustproduction,knowingthatnochangeinrelativepriceshas occurred.LucasusedthisinsighttoexplainwhythePCinacountrylikeArgentina withhighmacrovolatilitywouldbemuchsteeperthaninacountryliketheUSwithlow macrovolatility. TheconceptofrationalexpectationsledLucasandhisfollowerstomakea startlingprediction.HearguedthatanticipatedmonetarypolicycannotchangerealGDPin aregularorpredictableway,aresultsoonknownasthepolicyineffectiveness proposition.IncommonwithFriedmanandPhelps,theLucasapproachimpliedthat movementsofoutputawayfromthenaturallevelrequireapricesurprise,sothatthe

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centralbankcannotalteroutputbycarryingoutapredictablechangeinmonetary policy,onlybycreatingasurprise(theformaldevelopmentofthepropositionwas carriedoutinSargentWallace1975.) Bytheendofthe1970stheLucasapproachwaswidelycriticized.Theproblem wasnotLucasintroductionofrationalexpectations,butratherthetwinassumptions inheritedfromFriedmanandPhelps,namelycontinuousmarketclearingandimperfect information.Deviationsofthecurrentactualpricelevelfromtheexpectedpricewere theonlyallowablesourceofbusinesscyclemovementsinrealGDP.Thus,despitethe widespreadappealoftheFriedmanPhelpsLucasapproach,itranagroundonthe shoalsofaninadequatetheoryofbusinesscycles.Withmonthlyinformationavailable ontheaggregatepricelevel,thebusinesscyclecouldlastnomorethanonemonth. 5 In therecentevaluationofSims(2008,p.4),themicroeconomicunderpinningsoftheLucas supplycurvewerehighlyabstractandunrealisticforexamplemodelsof`island economiesinwhichpeoplehadtoinferthevalueoftheeconomywideinterestrateor moneystockfromthepricelevelontheirownisland.EvenLucaslaterconfessedthat Monetaryshocksjustarentthatimportant.ThatstheviewIvebeendrivento. Theresnoquestionthatsaretreatinmyviews(Cassidy,1996,p.53). 2.5RejectionoftheEmpiricalCaseAgainstMonetaryNeutrality Whateverthemodelusedtoexplainthebusinesscycle,thenaturalrate hypothesisandlongrunmonetaryneutralityareintactifempiricalcoefficientsimply thatareductionoftheunemploymentratebelowacertainlevel(whetheritiscalledthe naturalrateorthefullemploymentrate)leadstocontinuouslyacceleratinginflation.In thefirstfewyearsaftertheFriedmanPhelpsarticles,thosewhohaddeveloped econometricmodelssupportingapermanentlongruntradeoffclaimedthatthevalidity oflongrunneutralitycouldbetestedbyestimatingwhetherthesumofcoefficientson thelaggeddependentvariableinaninflationequationwasequaltounityorwas significantlybelowunity.Hereweignorethedistinctionbetweenwageandprice changesandexaminetherelationshipbetweentheinflationrate(p t),itslaggedvalue (pt1),andtheunemploymentrate(Ut): pt="pt1+$Ut+et(2) Heretheresponseofinflationtounemploymentisnegative(<1).Ifthesumof coefficientsonlaggedinflationissignificantlybelowunity,theninthelongrunwhenpt =pt1thereisalongruntradeoffbetweeninflationandunemployment:

5. Lucas(1973,equation(3),p.327)createdaseriallycorrelatedbusinesscyclebyintroducinga laggedvalueofcyclicaloutputintotheequationexplainingcyclicaloutputbythepricesurprise. Thislaggedtermisgratuitousandneithercalledforbythetheorynorconsistentwithit.

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pt=Ut/(1)(3) Numerousresearchpaperswritteninthelate1960sandearly1970splacedmajor emphasisonthefindingthatthecoefficientwassignificantlybelowunity,implyinga permanenttradeoffasinequation(3).However,theseresultswereephemeraland quicklyabandonedfortworeasons.First,asthesampleperiodextendedovermoreof theperiodofacceleratingwageandpricechangeinthelate1960s,thecoefficientkept creepingupandby1972hadreachedunity,particularlywhenthecoefficientwas allowedtovaryovertime. 6 Thesecondandmoreimportantreasontoabandonthistestofthelongrun tradeoffwasSargentssimplebutdevastatingeconometricpoint.Herewesimplify Sargentsexpositionbysuppressingthedifferencebetweenwagesandprices,andby makingexpectedinflationdependonlyonasinglelagofinflationratherthana distributedlag.Theoriginalspecificationisnot(2)butrather pt="Ept+$Ut+et(4) whereEptistheexpectedrateofinflation.Anobservableproxyforexpectedinflation mustbeobtained,andthisrequirementissatisfiedbybackwardlookingoradaptive expectations: Ept=vpt1(5) When(5)issubstitutedinto(4),weobtain: pt="vpt1+$Ut+et(6) NowSargentspointbecomesclear;thesingleequation(6)cannotbeusedtoestimate bothandv. Theonlywaythat canbeinterpretedasthecoefficientonexpected inflationisforanextraneousassumptiontobeintroduced,inparticularthatv=1. Yet,Sargentargues,thereisnoreasonforvtobeunity,andratheriftheinflation ratecanbeapproximatedasacovariancestationarystochasticprocess,vmustbeless thanunity.Forvtobeunity,theinflationratewoulddisplayextremelystrongserial correlationordrift,butduringmuchofUShistorybefore1950theinflationrate displayedrelativelylittleserialcorrelation.Thusitisquitepossiblethat wasequalto unitythroughoutthepostwarerabutthatvgraduallyincreasedwiththehigherserial
6.EcksteinandBrinner(1972)producedthefirstpapertoemergewithaspecificationinwhich thecoefficientwasunity.Gordon(1972)concurred,basedonadifferentparameterizationofa timevaryingcoefficientandprovidedcomparisonsofhisapproachwiththoseofEckstein BrinnerandPerry(1970).

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correlationofinflationinthe1960sthaninthe1940sand1950s.Inshort,Sargentmadea convincingcasethatthepreviouseconometricestimatesof inthecontextofequation (2)hadnorelevancetothevalidityofthenaturalratehypothesis.Notsurprisingly, sucheconometricexercisesceasedquiteabruptlyafter1972. Sargentsobservationthatthevcoefficientshouldbesmallerinperiodswithless serialcorrelationoftheinflationratewassubsequentlyvalidated.Gordondeveloped quarterlydatabackto1892andshowedthatthesumofcoefficicentsonlaggedinflation rosefrom0.40in18921929to0.60in192953andthento1.06in195480(Gordon,1982a, Table3).Wereturntohisresultsbelow,becausetheydirectlyaddresstheshiftingform ofthePCrelationshipduringthetwoworldwarsandduringtheGreatDepressionthat wasoriginallynoticedbySamuelsonSolow(1960). 7

3.

Post1975LeftForkintheRoad:TheDynamicDemandSupplyModel withInertia

The1960swerethegloryyearsofthePCsinterpretationasanegative correlationbetweeninflationandunemployment.Initiallyitwasviewedasa permanentnegativetradeoff,andsubsequentlyasashortruntradeoffsubjecttothe longerrunadjustmentofexpectationsinthenaturalratePC.Butalmostfromthe beginning,thedecadeofthe1970sseemedtooverturnanythoughtthatthenegativePC tradeoffwasintactorstable.Thenatureoftheproblemisevidentwhenwelookagain atFigure1,whichplotstheinflationandunemploymentratesinquarterlydatasince 1960,withthefourquarterchangeinthePCEdeflatorusedtorepresentinflation.For the1970sasawhole,theinflationunemploymentcorrelationisstronglypositive,not negative,andinFigure1,sharpchangesintheinflationrateappeartoleadbyaboutone yearchangesinthesamedirectionoftheunemploymentrate. WhenplottedinFigure2onascatterdiagramfrom1960to1980theinflationand unemploymentratesareuncorrelated,withacombinationofnegativeandpositive correlationsthatrangealloverthemap.ThenegativePCtradeoffappearedtobeutterly defunct.Inflowerylanguagethatamountedtoasimultaneousdeclarationofwarand announcementofvictory,LucasandSargent(1978,pp.4950)describedthetaskwhich facescontemporarystudentsofthebusinesscycle[is]thatofsortingthroughthe wreckage...ofthatremarkableintellectualeventcalledtheKeynesianRevolution. Theyear1975marksaclearbreakinthehistoryofthePhillipsCurve.Surveys writtenatthetimefocusonthedemiseoftheshortruntradeoffandtheemergenceof

7.SeealsoPakko(2000)forastudyofdifferencesintheshapeoffrequencydistributionsof inflationandoutputoverthepreandpost1929period.

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theconsensusexpectationalnaturalratePC(seeforinstanceLaidlerandParkin,1975). Twocomplementaryreasonsleadustomark1975asthetransitionyearforPCdoctrine. First,itwastheyearofthepublicationofthepolicyineffectivenessproposition summarizedabove,whichwasthebeginningoftheendofbusinesscycletheorybased onexpectationerrors.Second,1975wasayearinwhichboththeUSinflationand unemploymentratesexperiencedthemaximumimpact(atleastuptothattime)of supplyshocks,callingforarevisedPCtheorythatexplicitlyincorporatedsupply shocks. ThedemiseoftheFriedmanPhelpsLucasinformationbarriersmodeloccurred intwostages.First,thetheorywasflawedbyitsinabilitytoreconcilemultiyear businesscycleswithonemonthlagsfacedbyagentsinobtainingcompleteinformation abouttheaggregatepricelevel.Second,theattempttodevelopanempiricalcounterpart ofthepolicyineffectivenesspropositionwasaresearchfailure.Itflounderedonthe inabilitytodevelopasymmetricexplanationofoutputandpricebehavior.Barro(1977) showedthatoutputwasnotrelatedtoanticipatedmonetarychangesbutcouldnot demonstratetherequiredcorollarythefullandpromptresponsivenessofprice changestoanticipatednominaldisturbances.Thisfailurereflectedthefundamental conflictbetweenthefullyflexiblepricesrequiredbythemodelandtheinflationinertia deeplyembeddedintotheUSinflationprocess,aconflictthathasreturnedtohauntthe applicationoftheNKPCapproachinthepastdecade.SoonMishkin(1982)andGordon (1982a)showedthatanticipatedmonetarychangeshadastrongeffectonoutputinthe shortrunandoninflationinthelongrun,preservinglongrunbutnotshortrun neutrality. Theyear1975marksabreakpointinthehistoryofthePC.Since1975the developmentofPCdoctrinehasbifurcatedintotwodivergentpaths,calledherethe leftforkandrightforkoftheroad,withnosignofconvergence.Theleftforkinthe road,treatedinPart3ofthispaper,istheresurrectionofKeynesianeconomicsinthe formofawhatIcallthemainstreamPCmodelthatincorporateslongrunneutrality andanexplicitroleofsupplyshocksinshiftingthePCupordown,togetherwithan interpretationoftheinfluenceofpastinflationasreflectinggeneralizedinertiarather thanexpectedinflation.Therightforkintheroadofthepost1975evolution,examined inPart4below,featuresanapproachdevelopedbyKydland,Prescott,andSargent,and morerecentlybyGal,Gertler,andothers.Inflationdependsonforwardlooking expectations,andexpectationsrespondrationallytoactualandexpectedchangesin monetaryandfiscalpolicy.Thistwowaygamebetweenpolicyandexpectation formationleavesnoroomforsupplyshocksorinertia.

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3.1TheResurrectionofthePC SeveralyearsbeforethefamouswreckagepronouncementbyLucasand Sargent,theresurrectionofthePCbegan.Thefirstandperhapsmostimportantelement wasthenewtheoryofpolicyresponsestosupplyshocks,developedindependentlyby Gordon(1975)andPhelps(1978)intwoslightlydifferentmodelsthatwerelatermerged byGordon(1984).TheGordonPhelpsmodelmodelstartsfromthepropositionthat thepriceelasticityofdemandofthecommodityexperiencingtheadversesupplyshock, e.g.oil,islessthanunity,sothatfollowinganincreaseintherelativepriceofoil,the expenditureshareofthatcommoditymustincreaseandtheexpenditureshareofall othercomponentsofspendingmustdecrease.Forinstance,energysshareofnominal USGDPtripledbetween1972and1981. 8 Therequiredconditionforcontinuedfullemploymentistheopeningofagap betweenthegrowthrateofnominalGDPandthegrowthrateofthenominalwage (Gordon,1984,p.40)tomakeroomfortheincreasednominalspendingonoil.If nominalwagesareflexible,oneoptionisforthegrowthrateofwagestobecome negative,allowingthegrowthrateofnominalGDPtoremainfixed.Atthealternative extremewithrigidwages,toavoidadeclineinnonenergyoutputanaccommodating monetarypolicymustboostnominalGDPgrowthbytheamountneededtopayfor theextraspendingonoil,butthiswillleadtoaninflationaryspiralifexpectations respondtotheobservedincreaseintheinflationrate.Athirdalternative,andtheone thatactuallyoccurredinthe1970s,wasacombinationofwagerigiditywithapartial responseofnominalGDPgrowth,pushingdownbothrealnonenergyspendingand employment. By1976thismodelhadmadeitswayintothepopularpresswhenaNewYork Timesheadlineannounced,ANewTheory:InflationTriggersRecession(July18,1976, p.F13).Indeed,wecanseeinFigure1thatthroughouttheperiod197481,therewasa timeleadofroughlyoneyearofinflationrelativetounemployment.Thisrealworld result,thatanadversesupplyshockcandepressrealoutputandemploymentinaworld ofstickynonoilprices,hadbeenchristenedbyOkunin1974conversationsasa macroeconomicexternality. 9

8.WhiletheGordonandPhelpspaperswerethefirsttodevelopthetheoryofpolicyresponses tosupplyshocks,PierceEnzler(1974)hadpreviouslyrunsimulationswithalargescale econometricmodelthatshowedlargemacroeconomicimpactsofcommoditypriceshocks,witha tradeoffbetweentheoutputandinflationeffectsasthepolicyresponsevaried. 9.Blinder(1981)subsequentlyextendedthetheoreticalanalysistoallowforrationalexpectations intheformationofwagesandforadistinctionbetweenanticipatedandunanticipatedshocks. ThetopicwasmorerecentlyrevisitedbyBallandMankiw(1995).

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SometimestheoutputeffectofthesupplyshockintheGordonPhelps frameworkislikenedtoanoiltaxthatreducesnonoilrealconsumptionbymore,the smalleristhepriceelasticityofdemandforoil.Theextentoftheresultingdeclineinreal outputdependsnotonlyonthatelasticity,butontheresponseofnominaldemand whichinturndependsnotjustontheresponseofmonetarypolicybutalsoon additionalfactorslistedbyBlinderRudd(2008)bracketcreepinanonindexedtax system,negativewealtheffects,scrappageofobsoletecapital,andtheeffectof uncertaintyindampeningdemand. By1977supplyshockshadbeenincorporatedintothenaturalrateexpectational PhillipsCurve.Thistheoreticalformulation(Gordon,1977a,equation13),exceptforthe absenceofexplicitlaggedterms,isidenticaltotheeconometricmainstreammodel developedsubsequentlyanddescribedbelow: p t=Ept+b(UtUNt)+zt+et,(7) wherethenotationisthesameasabovewiththeadditionofUNttorepresentthenatural rateofunemploymentandzttorepresentcostpushpressurebyunions,oilsheiks,or bauxitebarons(Gordon,1977a,p.133).Othertypesofsupplyshocksincludethe impositionandterminationofpricecontrols(asintheUSin197174),changesinthe relativepriceofimports,andchangesinthetrendgrowthofproductivity.Episodesin whichpoliticaleventscausesharpchangesinwages,suchastheFrenchgeneralstrikeof 1968,alsoqualifyasadversesupplyshocks.Adetailednarrativeoftheroleoffood,oil, andpricecontrolshocksintheinflationofthe1970sisprovidedbyBlinder(1979,1982). Theprocessofintegratingsupplyshocksintomacroeconomicstookplace simultaneouslyduring197578onthreefronts,theoreticalasdescribedabove,empirical asdescribedbelow,andinanunusualdevelopment,throughanewgenerationof intermediatemacroeconomictextbooks.Anexplanationwasneededtoreconcilethe dominantroleofdemandshocksastheexplanationoftheGreatContractionof192933 inthesamemodelaswouldexplainthepositivecorrelationofinflationand unemploymentin197475.Oncerecognized,thatexplanationbecameobvious.Justas theoutputandpriceofcornorwheatcouldbepositivelyornegativelycorrelated dependingontheimportanceofmicrodemandorsupplyshocks,soaggregateoutput andtherateofinflationcouldbepositivelyornegativelycorrelated,dependingonthe relativeimportanceofaggregatedemandorsupplyshocks. Thetextbooksappearedsimultaneouslyin1978andbothusedalternative versionsofasimplediagramthatcanbetracedbacktoaclassroomhandoutusedby DornbuschattheChicagoBusinessSchoolinearly1975. 10 Thediagram,whichhasthe
10.The1978rivaltextbookswerebyDornbuschandFischerandbymyself.Thedynamic versionofthedemandsupplymodelintheformofafirstorderdifferenceequationwasconfined tointermediateleveltextbooks,withmanyimitatorspublishedsoonafter.Elementarymacro

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inflationrateontheverticalaxisandeithertheunemploymentoroutputgaponthe horizontalaxis,combinesthreeelementstheexpectationalPC,shiftsinthatPCcaused bysupplyshocks,andanidentitythatdecomposesnominalGDPgrowthintoinflation andoutputgrowth.Thetextbookversionshowsthatthedynamicaggregatedemand supplymodelimpliesasimplefirstorderdifferenceequation.Followingapermanent upwardordownwardshiftinnominalGDPgrowth,anylagsintheformationof expectedinflationcausetheeconomytocyclethroughloopstoitsnewlongrun equilibriumatazerovalueoftheunemploymentoroutputgapandapermanently higherorlowerrateofinflation. 3.2EconometricImplementationoftheMainstreamModel Asinequation(7)above,themainstreamspecificationoftheinflationprocess containsthreesetsofexplanatoryvariablesrepresentinginertia,demand,andsupply, leadingmetocallitthetrianglemodel. 11 Replacingtheexpectedinflationtermisaset oflonglagsonpastinflation,reflectingtheviewthattheinfluenceofpastinflation reflectsgeneralizedbackwardlookinginertia,notjusttheformationofexpectations. Importantsourcesofinertiaincludethesetofexplicitandimplicitcontractsthat dampenshorttermchangesinpricesandwages(asrecognizedexplicitlybyFisher, 1926),andtheinputoutputsupplychainthatcreatesthousandsoflinksofunknown magnitudeanddurationbetweenchangesincrudeandintermediategoodspricesand thepricesoffinalgoods,asemphasizedbyBlanchard(1987).Allofthesechannels interacttocreatetheinertiaeffect,thefirstlegofthetriangle. ThisapproachisKeynesianbecausetheroleofinertiaistomaketheinflation rateslowtoadjusttochangesinnominaldemand,andasaresultrealGDPemergesasa residual,notasanobjectofchoiceasinFriedmanPhelpsLucas.Avasttheoretical literatureundertherubricofNewKeynesianEconomics(NKE),startinginthelate 1970swithFischer(1977)andTaylor(1980),providednumerousmodelstomotivatethe inertiamechanismbyexplainingrealandnominalrigidityofwagesand/orprices,and manyoftheseexplicitlyincorporatedrationalexpectations. 12 InourdiscussioninPart4 below,wewillbecarefultodistinguishbetweenthetheoreticalmodelsoftheNKEfrom theempiricalapplicationoftheNKPC. Inthetrianglemodelthespeedofpriceadjustmentandthespeedofexpectation formationaretwototallydifferentissues.Priceadjustmentcanbedelayedbywageand
principlestextbookslimitedthemselvestothedisplayofstaticaggregatedemandandsupply curves,startingwithBaumolandBlinderin1979. 11.Thetrianglenomenclaturehasbeenpickedupbyaseveralauthors,includingRudd Whelan(2005b)andFitzenberger,Franz,andBode(2008). 12.ThetheoreticalNKEresearchliteratureissurveyedandplacedintheperspectiveofhistorical puzzlesofpriceandwagebehaviorinGordon(1990).

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pricecontracts,andbythetimeneededforcostincreasestopercolatethroughtheinput outputtable,andyeteveryonecanformexpectationspromptlyandrationallybasedon fullinformationaboutthehistoricalresponseofpricestoitsownlaggedvalues,to demandshocks,andtosupplyshocks. Thedemandsideofthemodelisrepresentedbythelevelandchangeofthe outputgaporalternativelytheunemploymentgap.Aswehaveseenabove,Phillips recognizedtheroleoftherateofchangeeffectthatatanygivenunemploymentrate makestheinflationratehigherwhentheunemploymentrateisfallingthanwhenitis rising.Becausetheunemploymentgapisalwaysenteredinthetrianglemodelwith boththecurrentvalueandwithadditionallags,thezigzagoftheestimatedlagged coefficientsbetweennegativeandpositivecanincorporatetherateofchangeeffect. Thesupplysideofthemodelisrepresentedbyasetofexplicitsupplyshock variables,establishingacontrastbetweenthemainstreamapproachandtherecent NKPCliteraturewherethesupplyshockeffectsarealwayshiddenintheerrorterm. Theexplicitsupplyshockvariablesarealldefinedsothattheabsenceofsupplyshocks isrepresentedin(7)asz t=0.Suchvariables,forinstance,includechangesintherelative priceofoilandchangesintherelativepriceofnonoilimports;whentheserelativeprices exhibitzerochange,thereisnoupwardordownwardpressureontheinflationratefrom supplyshocks.Thelistofsupplyshockvariablesincludesdummyvariableswhich measuretheimpactofthe197174Nixonerapricecontrolsinholdingdowninflationin 197173andthenaddingtothesupplyshockimpactoninflationin197475. 13 Earlier versions(Gordon1982b,GordonKing1982)includedchangesintherealexchangerate inplaceofrealimportprices. Unfortunately,theessentialroleofstickywagesand/orinflexiblenonoilprices wasmissedbymanyanalystswholatertriedtomodeltheimpactofoilpricesonreal output.ForinstanceBrunoandSachs(1985)useaneoclassicalproductionfunctionto showthattheelasticityofoutputwithrespecttotherealenergypriceistheenergyshare ingrossoutput,thusmissingthemacroeconomicexternality.Hamilton(1983)ina muchcitedpapershowedthatoilpricesGrangercausechangesinrealoutputinallbut oneoftherecessionsthatoccurredbetween1948and1980.Hamiltonsresultscannotbe comparedtothoseofBrunoSachs,orthoseimpliedbythetriangleinflationequation, becauseheprovidesnoelasticityestimatesandnoanalysisoftheextenttowhichtheoil
13.ThestudyofwageandpricecontroleffectsbeganwithGordon(1972).Nixoneracontrol dummieswereincludedinalltheeconometrictestsoftheGordonmainstreammodelbeginning withGordon(1977b).Thecurrentversionofthetrianglemodel(seeTable1below)estimatesthat theimpositionofcontrolsreducedthepricelevelbyacumulative1.6percentandtheremovalof thecontrolsraisedthepricelevelby1.8percent.UsingCPIratherthanPCEdata,andwitha slightlydifferentmethod,BlinderandNewton(1981,Table2,Model1)estimatedthatthe controlshelddownthepricelevelbyacumulative3.1percentthroughearly1974,followedbya 3.2percentbouncebackin197475.

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priceeffectworksthroughoverallinflation,asintheGordonPhelpsmodel,orthrough adirectimpactofoilonoutputviatheproductionfunctionasinBrunoSachs. Sincethe1970stheliteratureonsupplyshockshascomeincreasinglytofocuson oilandtoneglectshocksrelatedtochangesintherelativepriceoffood,ofnonoilnon foodimports,andtheeffectsoftheNixonerapricecontrols.Infact,foodratherthanoil wastheexampleusedintheinitialdevelopmentofthemacroexternalitytheoryin Gordon(1975).BosworthLawrence(1982)provideamplebackgroundonthereasons forsustainedincreasesintherealpriceoffoodin197374andin197879(anothersuch episodeoccurredin200708). BlinderandRudd(2008)revisitthesupplyshockexplanationoftheGreat Stagflationofthe1970sandearly1980sandconfirmitscentralrole.Theysummarizea setofargumentsagainstthesupplyshockexplanationandrefuteeach.Tothose (includingBarskyandKilian2002)whocannotunderstandwhyachangeinarelative pricewouldberelevantforoverallinflation,theypointtotherigidityofpricesinthe nonshockedsector.Theyalsoassessarguments(likethoseofBernanke,Gertler,and Watson1997)claimingthattheimpactofoilshocksontheeconomyactuallyrepresents theeffectsofthecentralbankresponseratherthantheoilshockitself.Theyprovide newevidencefromastructuralVARmodelreaffirminganindependentroleforoil shocks.Infact,givenampleempiricalevidenceoflonglagsintheresponseofoutput andunemploymenttomonetarypolicyactions,theBlinderRuddresultsmakeperfect senseanadversesupplyshockcausesaninitialspikeofunemployment,andthe monetarypolicyresponsethendeterminesbyhowmuchunemploymentdeclinesinthe subsequentyearsaftertheshock. SincetheoriginalPhillips(1958)articlewasaboutwagechanges,notprice changes,itisnoteworthythatthetrianglemodelisasinglereducedformequationfor theinflationrate,withnomentionofwagechanges.Startingfromseparatewage changeandpricemarkupequations,ashadbeenstandardinthePCeconometrics literatureuptothattime,Gordon(1982b)mergedthetwoanddiscussedthesimplifying assumptionsneededtoperformthemerger,particularlytheabsenceofwagewage inertia. Theusualassumptionthatinflationisequaltonominalwagechangesminus productivitygrowthassumesafixedvalueoflaborsshareinnationalincome.But laborsincomesharerosesharplyinthelate1960sandhasdrifteddownsincethen.The goalofthecentralbankistocontrolinflation,notwagechanges,sochangesinlabors incomeshareacrossbusinesscyclesimplyalooserelationbetweeninflationandwage changesthatisfruitfullyignored.Animportantcontributiontothedemiseofthewage equationwasmadebySims(1987),whoarguedthatwageandpriceequationshaveno separatestructuralinterpretations,andthatapriceequationisawageequationstoodon itshead,andviceversa.

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 3.3EmpiricalResults:StrengthsandWeaknesses Thecurrenteconometricversionofthemainstreamortrianglemodelwasoriginally developedinthelate1970s(Gordon1977b)andpublishedinitscurrentform(asasingle reducedformpriceonpriceequationwithnowages)inGordon(1982b).Ithasbeen maintainedessentiallyintactsincethen,withthesamesetofexplanatoryvariablesand laglengths,inordertoallowpostsamplesimulationstoidentifyforecastingerrorsthat maycallforrethinkingthespecification.Thefirstchallengetothemodelarrivedalmost immediatelyintheformoftheVolckerdisinflationof197986.AsshowninFigure1, theinflationratecollapsedfromnearly10percentin1981toonly3percentin198384, muchfasterthanhadbeenforecastbycommentatorsusinganexpectationalPCwitha heavyemphasisonwagerigidity. Thesacrificeratioisaconvenientsummarymeasureofthespeedofinflation adjustmentinresponsetohighunemploymentandlowoutput.Thisratioisdefinedas thecumulativeyearsofoutputgapduringthedisinflationdividedbythepermanent reductionofinflationexpressedasanabsolutevalue.Someexanteforecastsofthe sacrificeratiomadein198081wereashighas10,buttheactualsacrificeratioin retrospectturnedouttobebetween3.5and4.5. 14 Thekeytothesurprisinglylow sacrificeratioturnedouttobetheroleofsupplyshocks,andinparticularthe198186 declineintherelativepriceofenergyandthe198085appreciationofthedollarwhich reducedtherelativepriceofimports.Inaremarkableforecastingsuccessachievedin themiddleofthedisinflation,GordonKing(1982)estimatedasixequationVARmodel thatcombinedthetriangleinflationequationwithequationsthatallowedmonetary policytoinfluenceendogenousoilpricesandtheexchangerate,andtheirmainresult wasasacrificeratiointherangeof3.0to3.5,muchbelowtheprevailingwisdomofthe time.15 TheGordonKingresultisconsistentwiththeKydlandPrescottSargent interpretationreviewedinthenextsectionthatmakesnomentionofsupplyshocksbut ratheremphasizestheinterplaybetweenthecredibilityofthecentralbankandthe expectationsofthepublic.Nodoubtamajorroleinthespeedofthedisinflation,and theresultingrelativelysmallsacrificeratio,wasthewidespreadperceptionthatthe Fedsmonetarypolicychangedafter1979anditsantiinflationstancebecamemore crediblethanbefore.TheadvantageoftheGordonKingmethodisthatthechannelsof monetarypolicyareexplicitlytraced,notjustthroughhighunemploymentbutalso
14.TheconceptofthesacrificeratiowasdevelopedbyOkun(1978),andhispreferredestimate ofthesacrificeratiowas10(p.348). 15.Inapaperwritteninearly1981,Gordon(1982b,Table10)integratedanendogenousflexible exchangerateintotheeffectsofahypotheticalVolckerdisinflationandsimulatedasacrificeratio of4.8,arelativelylownumberthatresultedinpartfroma33percentexchangerateappreciation.

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throughtheeffectofthemonetaryfiscalpolicymixincausinganappreciationofthe dollarin198085,withanaccompanyingdeclineintherelativepriceofoilandofnonoil imports. ReturningnowtoFigure1,weseethattheVolckerdisinflationwasfollowedinthe late1980sbyarepeatofthenegativeinflationunemploymenttradeoffalready experiencedinthe1960s,albeitwithasmalleraccelerationofinflationandahigherlevel ofunemployment.Similarly,thenegativetradeoffisevidentintheslowdownof inflationin199093inresponsetoamarkedincreaseintheunemploymentrateduring thesameperiod. Atfirstglance,thebehaviorofthePCinthe1990sappearstobepuzzling. Unemploymentinthelate1990sfelltothelowestratesincethe1960s,buttherewasno parallelaccelerationofinflation.Instead,inflationwaslowerin2000thanin1993.As shownbyGordon(1998),lowinflationinthelate1990scanbeexplainedbybeneficial supplyshocksthatpushedthePCdownincontrasttotheadversesupplyshocksofthe 1970s;thebeneficialshocksofthe199699periodincludedlowerrealenergyprices, lowerrelativeimportprices,andfastertrendproductivitygrowth.AsshowninFigure 1,thetwinpeaksofinflationandunemploymentwerejoinedbythevalleyof inflationandunemploymentduring19972000. Despitetheseresearchsuccesses,theevolutionofthedatarequiredonechangein the1982specificationofthetrianglemodel.Postsamplesimulationsin199495revealed thatthemodelspredictionshadstartedtodriftinthedirectionofpredictingtoomuch inflation,givenactualvaluesoftheunemploymentgap.Theseerrorsturnedouttobe duenottoaflawinthemodelbuttoadatachoice,thatis,thefalseassumptionthatthe naturalrateofunemploymentwasfixed,allowedtochangeonlyinresponsetothe demographiccompositionoftheunemploymentrate. 16 Forseveraldecadesthenaturalrateofunemploymenthasbeencalledbyits nickname,theNAIRU,standingforNonAcceleratingInflationRateof Unemployment.ThetimevaryingNAIRU(orTVNAIRU)combinedaneconometric methodintroducedbyStaiger,Stock,andWatson(1997)thatwasappliedtoaversionof mytrianglemodel,andsimultaneouslyIpublishedapaperwhichusedtheirmethod appliedtomymodel(Gordon,1997).TheestimatedTVNAIRUexhibitedapronounced downwarddriftafter1990thatexplainedinamechanicalwaywhytheinflationrate waslowerinthe1990sthanhadpreviouslybeenpredictedwithafixedNAIRU.An initialsetofsubstantiveexplanationsofthisdeclineintheNAIRUwasprovidedbyKatz andKrueger(1999).
16.Thepre1994estimateoftheNAIRUincorporatedchangesinthedifferencebetweenthe officialunemploymentrateandthedemographicallyadjustedunemploymentrate,originally introducedbyPerry(1970).ThePerryweightedNAIRUwasassumedtobefixed.

21

 4. Thealternativepost1975researchapproach,therightforkoftheroad, emphasizesjumpsinexpectationsinresponsetopolicyactionsandimplicitly incorporatespriceflexibility,marketclearing,andanabsenceofbackwardlooking inflationinertia.Thecentralideathatexpectedinflationcanjumpinresponsetoactual oranticipatedpolicychangesiscrucialtounderstandingtheendsofhyperinflations (Sargent,1982).Itbeginswiththebasicproposition,alreadyembeddedinthe FriedmanPhelpsnaturalratehypothesis,thatthechoicebyapolicymakerofa particularshortruncombinationofinflationandunemploymentratescanalter expectations,causingthetradeofftochange. 4.1ThePolicyGame KydlandPrescott(1977)distinguishedbetweenpolicydiscretionandrules, contrastingdiscretionarypolicymakerswhoreassessthedesiredresponsetoalternative inflationratesineachsuccessivetimeperiod,withrulefollowingpolicymakerswho adheretoarulewhichisfixedforallfuturetimeperiods.Theyshow,notsurprisingly, thatthelongruninflationrateishigherunderadiscretionarypolicythanarulesbased policy.Howdoesthisapproachexplainthepositivecorrelationofinflationand unemploymentinthe1970swithoutmentionofsupplyshocks?Paperswrittenby Sargent(1999),CogleyandSargent(2005),andSargentetal.(2006),beginwiththe standardpresumptionthatchoicesbydiscretionarypolicymakerswillcausethePCto shiftandpolicyoptionstochange.Theattempttoconductpolicywithoutknowledgeof thecurrentpositionofthePhillipscurvecanleadapolicymakertomakechoicesthat yieldpersistentlyhighinflationoutcomes. Credibilityisanimportantconceptinthegameinvolvingpolicymakersand privateagents.Becauseexpectationscanjumpinresponsetochangesinpolicymakers actionsandperceivedintentions,theoutcomeofactualinflationishigherifagentsinfer thatthepolicymakeristryingtomanipulateunemploymentalongtheshortrunPC tradeoff.Acrediblepolicyisonewhichpromisestomaintainalowinflationrateinthe longrun;agentsareconvincedthatapolicyiscredibleifthepolicymakerspursuean inflationtargetandregularlyraisetheinterestratewheninflationexceedsitstargetbut donotlowerinterestratesinresponsetoanincreaseinunemployment.Doubtsby agentsthatthepolicymakeriscommittedtolowinflationinthelongruncanraisethe unemploymentcostofreducinginflation,i.e.,thesacrificeratio.

ThePost1975RightForkintheRoad:JumpingandForwardLooking PolicyResponsiveExpectations

22

Oneproblemwiththislineofresearchisthatitignoresadditionalinformation availabletopolicymakersthatoilorfarmpriceshaverisen,thatthedollarhasbeen devalued,thatpricecontrolshavebeenimposedorended,orthattrendproductivity growthhasslowedorrevived.IndeeditisstrikingthatSargentetal.(2006)claimtobe abletoexplaintheentireupsurgeofinflationinthe1970sandearly1980swithoutany mentionofsupplyshocks,despitethefactthatthewordshocksappearsinthetitleof theirpaper:...allowthemodeltoreverseengineerasequenceofgovernmentbeliefs aboutthePhillipscurvewhich,throughtheintermediationofthePhelpsproblem, captureboththeaccelerationofU.S.inflationinthe1970sanditsrapiddeclineinthe early1980s. Anotherproblemwiththepolicygameapproachisthatitignoresthe policymakersfundamentaldilemmainthefaceofanadversesupplyshock.Asshown inGordon(1975,1984)andPhelps(1978),unlesswagesareperfectlyflexible,the policymakercannotescapeachoicebetweenholdinginflationconstantatthecostof substantialextraunemployment,orholdingunemploymentconstantatacostofhigher andacceleratinginflation,orsomethinginbetween.Infact,becauseoflonglagsinthe impactofmonetarypolicyonunemploymentandinflation,inrealitythepolicymakeris incapableofholdingeitherinflationorunemploymentconstantfollowingasupply shock. RelatedworkbyPrimiceri(2006)includesthegovernmentsunderestimateofthe NAIRUinthe1970sasacauseofhighinflation,buthedoesnotprovideanyexplicit analysisofsupplyshocksasthecauseofthisunderestimate.Sims(2008)hassuggested thatPrimiceriisguiltyofanasymmetry,becauseheallowsonlyforuncertaintyabout coefficientvaluesinamodelthatpolicymakersassumeiscorrect,insteadofallowingfor thefactthatthemodelmaybewrong.Infact,thediscussionaboveofthemainstream modelsuggeststhatPrimiceriandothersworkingonpolicyexpectationsinteractions mayindeedhavechosenthewrongmodel,atleastfortheUS,byassumingthat expectationscanjumpinresponsetopolicyannouncementsandignoringtheroleof backwardlookinginertiaandsupplyshocks. 4.2TheNewKeynesianPhillipsCurve(NKPC) TheNKPCmodelhasemergedinthepastdecadeasthecenterpieceofmacro conferenceandjournaldiscussionsofinflationdynamicsandaswhatBlanchardand othershavecalledtheworkhorseoftheevaluationofmonetarypolicy. 17 Thepointof theNKPCistoderiveanempiricaldescriptionofinflationdynamicsthatisderived
17.Blanchard(2008,p.8)usestheworkhorselabelforasmallthreeequationmacromodelof whichtheNKPCisoneequation,eventhoughhecallstheNKPCequationpatentlyfalse(p.9). WereturnbelowinPart5toquantifytheextenttowhichtheNKPCispatentlyfalseandleave tothereaderthepuzzleastohowthismodelcouldhavebecomeaworkhorse.

23

fromfirstprinciplesinanenvironmentofdynamicallyoptimizingagents(Brdsenetal. 2002). Thetheoreticalbackgroundisthatmonopolisticallycompetitivefirmshave controlovertheirownpricesduetoproductdifferentiation.Theyareconstrainedbya frictioninthesettingofprices,ofwhichtherearemanypossiblejustificationsthatare inheritedfromthetheoreticalNKEliterature.Forinstance,wehavealreadycited Taylors(1980)modelwhichmergesrationalexpectationswithfixeddurationcontracts. Morefrequentlycited,asinMankiws(2001)exposition,isCalvos(1983)modelof randompriceadjustment,inwhichpricesarefixedforrandomperiods.Thefirms desiredpricedependsontheoverallpricelevelandtheunemploymentgap.Firms changetheirpriceonlyinfrequently,butwhentheydo,theysettheirpriceequaltothe averagedesiredpriceuntilthetimeofthenextpriceadjustment.Theactualpricelevel, inturn,isequaltoaweightedaverageofallpricesthatfirmshavesetinthepast.The firstorderconditionsforoptimizationthenimplythatexpectedfuturemarket conditionsmatterfortodayspricingdecision.Themodelcanbesolvedtoyieldthe standardNKPCspecificationinwhichtheinflationrate(p t)dependsonexpectedfuture inflation(Etpt+1)andtheunemployment(oroutput)gap: pt=Etpt+1+(UtU*t)+et(8) Theconstanttermissuppressed,andsotheNKPChastheinterpretationthatif=1, thenU*trepresentstheNAIRU. NoticethattheNKPCinequation(8)isidenticaltothepost1975mainstreamPC writtenin(7)above,withtwodifferences.First,thereisnoexplicittreatmentofsupply shocks;thesearesuppressedintotheerrorterm.Second,expectationsareexplicitly forwardlookinginequation(8),whereasin(7)expectationscouldbeeitherforward lookingorbackwardlooking,orboth.BecauseoffrictionsoftheTaylororCalvotype, policychangesthatraiseorlowertheinflationratehaveshortruneffectsonthe unemploymentoroutputgap.TheTaylorNKEframeworkassumesfixedcontract lengthsofpricingintervals,whiletheCalvomodelmakespricechangesdependentona fixedgapbetweentheactualanddesiredpricelevels.ButSims(2008)pointsoutthat thistheoryhassimplymovedthenonneutralityfromagentbehavioritselfintothe constraintstheagentfaces,thefrictions.Inrealworldsituationsinwhichmacro shockscreateArgentinalikeinstability,contractlengthswouldsurelychangein responsetotheexpectedinflationrate. NKPCmodelsvaryintheirinclusionofthesinglevariablethatsupplements futureexpectedinflation.Sometimesthisismodeledastheunemploymentgap,asin (8),andsometimesasthecloselyrelatedoutputgap.Mankiws(2001)exposition followedbelowusestheunemploymentgap.

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 AnotherversionoftheNKPCreplaceseithergapwithrealmarginalcost.Thisis alwaysproxiedbyrealaveragecost,thatis,therealwagedividedbytheaverage productoflabor(W/P)(Y/N),whichisbydefinitionequaltolaborsshareinnational income(WN/PY).SomepapersintheNKPCliteraturetreatrealmarginalcostas exogenous,butthisisunacceptablebecauselaborsincomeshareisinherently endogenousandrequiresamultiequationmodelwithseparateequationsforthelevel ofthewagerate,thepricelevel,andtheleveloflaborproductivity.Thusfarempirical implementationofthemarginalcostversionoftheNKPChassweptundertherugthe endogeneityoflaborsincomeshare.IncontrastDewBeckerandGordon(2005)have examinedjointfeedbackbetweenpricesandwagesbyendogenizingchangesinlabors share. 18 Thissectiontreatstherightfork,withitsabsenceofinertiaandexpectations thatcanjumpinresponsetoanticipatedpolicychanges,asafruitfuldevelopmentin macroeconomicswhenappliedtorapidinflationepisodes,whetherinGermanyin1922 23orinBrazilorArgentinamorerecently.Unfortunately,theempiricalimplementation oftheNKPChasbeenalmostentirelytodataforthepostwarUS,whereitisthewrong model.Thiscanbeeasilyseenforboththegapandrealmarginalcostversionsof theNKPC.Thegapversionaswrittenaboveinequation(8)driveschangesinthe inflationrateonlywithchangesintheunemploymentgap,orequivalentlywiththe outputgap.Itspredictionisthatthecoefficient()ontheunemploymentgapis negative.ButwehavealreadyseeninFigure1thatthecorrelationbetweeninflation andtheunemploymentgapisbothnegativeandpositive,withapositivecorrelation between1971and1982whenthevarianceofinflationwasgreatest.TheNKPCcontains noelementtocapturetheswitchfromnegativetopositivecorrelationandbackagain. Correspondingly,themodelspredictionisthatwhentheunemploymentgapis replacedbytheoutputgap,thecorrelationshouldbepositive.ButasshowninFigure3, thecorrelationbetweeninflationandtheoutputgapisstronglynegativebetween1971 and1982.ThusitisnotsurprisingthatRuddWhelan(2005b,Table1)showthatthe estimatedcoefficientontheoutputgapissignificantlynegative.Theirresultisobtained bytheusualprocedureofreplacingtheunknownexpectationoffutureinflationwith twostageleastsquaresestimationinwhichthefirststageregressestheactualinflation rateonasetofinstruments. 19 Thisapparentconundrumisresolvedinthemainstream trianglemodelinwhichtheoutputgapleadsinflationpositively(asin196569and 198689)whileinflationleadstheoutputgapnegatively(asin197182)duetothe influenceofsupplyshocks. AlookatthedataalsopredictsafailureoftheversionoftheNKPCthatusesreal marginalcostasthevariablethatdrivesinflation.Asnotedabove,realmarginalcostis
18.Theinsightthatfeedbackbetweenwageandpriceequationsistransmittedthroughlabors sharedatesbacktoFranzGordon(1993). 19.TheyusethesamelistofinstrumentsasinGalGertler(1999),withtwolagsinsteadoffour lagsoneach.

25

alwaysproxiedbyrealaveragecost,whichisthesameaslaborsincomeshare,andthis shareisplottedagainsttheinflationrateinFigure4. 20 Laborsshareexhibitsonebig upwardjumpin196770,atleastfouryearstooearlytoexplainthefirstinflationpeakin 197475.After1970laborsshareisessentiallytrendless,varyingonlybetween70and75 percent,withnomovementsthatwouldhelptoexplainthesecondinflationpeakin 197981northeVolckerdisinflationof198184.Accordingly,itisnotsurprisingthat RuddWhelan(2005b,Table1)estimateaninsignificantcoefficientinequation(8)when realmarginalcostreplacestheunemploymentgap. TheNKPCliteratureseemstobejustasconfusedbythebehaviorofreal marginalcostasbythenegativecorrelationofinflationwiththeoutputgap.As Woodford(2003)haspointedout,thestandardmodelpredictsthatincreasesinoutput tendstobeaccompaniedbyhigherrealmarginalcostasworkersmoveoutapositively slopedlaborsupplycurve,asovertimepremiarise,andasinputmaterialscostsrespond positively.HoweverFigure4indicatesthat,atleastbefore1990,laborsincomeshare peakedinrecessionsandappearstobecountercyclical.Thishasaneasyexplanation thathasapparentlybeenneglectedinmanyNKPCdiscussions,theprocyclicalityof laborproductivity,whichappearsinthedenominatorofrealaveragecost.Rudd Whelan(2005b)alsodiscusstheproblemthatlaborsshare,whichequalsrealaverage cost,maybeapoorproxyforrealmarginalcost. 4.3TheChallengeofPersistence OnthesurfacetheNKPCaswritteninequation(8)appearssimilar,exceptfor theomissionofexplicitsupplyshockvariables,tothemainstreamPCaswrittenin equation(7).Butitspolicyimplicationsareradicallydifferentfromthemainstream model,withitscostlydisinflationandsignificantsacrificeratio.Thisoccursbecausein theNKPCmodelthereisnobackwardlookinginertia,thatis,nostructuraldependence ofinflationonitsownlaggedvalues.Instead,inflationisentirelydrivenbyforward lookingexpectations,andequation(8)canbesolvedforwardtosettheinflationrate equaltoaninfinitesumofexpectedfutureoutputgaps.Inflationcanbecostlessly controlledbyacrediblecommitmenttofollowpoliciesthatminimizetheoutputgap foreverintothefuture. However,asweshallseeinPart5,inflationpersistenceintheformoflonglags onpastinflationratesisacentralfeatureofpostwarUSinflationbehavior.Asaresult, intheUSenvironmentexpectationsareunlikelytojumpexceptinresponsetowidely recognizedsupplyshocks,suchasthesurgeofoilpricesin197375,197981,or200608.

20.LaborsshareinFigure4isdefinedasemployeecompensationdividedbydomesticnet factorincome(NIPATable1.10:GDPminusconsumptionoffixedcapitalminustaxeson productionandimportslesssubsidies).

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Therecognitionthat,intheabsenceofsupplyshocks,theinflationrateisdominatedby persistencecreatesachallengeforpolicymakerstoreduceinflationbyalteringpublic expectationsdirectly.Howcanpolicymakersconvincethepublicthatinflationwill spontaneouslydecrease,withoutanycostofhigherunemploymentorlostoutput,when thepublicknowsthatinflationbehaviorisdominatedbypersistence? Asweshowinsection5.1,inpracticetheNKPCissimplyaregressionofthe inflationrateonafewlagsofinflationandtheunemploymentgap.Aspointedoutby Fuhrer(1997),theonlysenseinwhichmodelsincludingfutureexpectationsdifferfrom purelybackwardlookingmodelsisthattheyplacerestrictionsonthecoefficientsofthe backwardlookingvariablesthatareusedinthefirststageoftwostageleastsquares estimationasproxiesfortheunobservablefutureexpectations.InFuhrerswords: Ofcourse,somerestrictionsarenecessaryinordertoseparatelyidentify theeffectsofexpectedfuturevariables.Ifthemodelisspecifiedwith unconstrainedleadsandlags,itwillbedifficultforthedatatodistinguish betweentheleads,whichsolveoutasrestrictedcombinationsoflag variables,andunrestrictedlags.(p.338) 4.4SubtletiesintheInterpretationoftheHybridNKPC GalandGertler(1999),twooftheinventorsoftheNKPCapproach,have introducedahybridNKPCmodelinwhichthepublicconsistsbothofforward lookingandbackwardlookingagents,andintheirempiricalversioncurrentinflation dependsonbothexpectedfutureinflationandpastinflation.However,sincefuture inflationisalwaysproxiedbysometransformationofpastinflation,thereislittle differenceinpracticebetweenthepureforwardlookingNKPCandthehybrid version,exceptfortheformoftherestrictionsthatemerge.Further,ifthereareenough backwardlookingmembersofthepopulation,thenforwardlookingmemberscannot ignorethepersistenceintroducedbybackwardlookingagents.Thisdependenceof futurecontractoutcomesontheinheritanceofongoingcontractswithstaggered expirationdateshasbeenexplicitinthetheoreticalNKEliteraturesinceitsintroduction byTaylor(1980). ThehybridNKPCmodelisthesameasequation(8)above,exceptthatthe influenceofinflationisdividedbetweenfutureexpectedinflationandlaggedinflation ratherthanbeingchanneledexclusivelythroughfutureexpectedinflation. p t=fEtpt+1+bpt1++(UtU*t)+et,(9) Thecentralissueistherelativesizeoftheforwardlookingandbackwardlooking coefficients(fandb).GalandGertler(1999)andGal,Gertler,andLopezSalido

27

(2005)havereportedestimatesofequation(9)withtheunemploymentgapreplacedby laborsincomeshareandconcludethatforwardlookingbehaviorisdominant,i.e.,f isestimatedtobemuchlargerthanb.Thisconclusionisimportant,sinceitappearsto justifytheoriginalformulationoftheNKPC(equation8above)andmakestheroleof laggedinflationappeartobeaminordistractionoflittleempiricalimportance. However,aspointedoutbyRuddWhelan(2005a,2005b),theseestimatesdonot actuallydistinguishbetweenforwardlookingandbackwardlookingbehaviordueto thenatureofthetwostageleastsquaresexercise.Thesecondstageequation(9above) omitsvariablesthatbelonginthetruemodelofinflation,e.g.,additionallagson inflationitselfaswellasexplicitsupplyshockvariableslikecommodityprices,but includestheminthefirststageasaproxyforexpectedfutureinflation.Indeed, anythingthatiscorrelatedwithcurrentinflationbutnotincludedinthesecondstage willserveasagoodinstrumentforfutureexpectedinflationandthusraise frelativeto b.Theseomittedvariablesboostthecoefficientonexpectedfutureinflationevenif expectedfutureinflationhasnoinfluenceatalloninflationitself,asoccurswhenRudd Whelanestimateapurebackwardlookingmodelthatincludessomeoftheadditional variablesincludedasinstrumentsinthetwostageprocedure.Overall,theNKPC approachtodatehasdeliverednoevidencethatexpectationsareforwardlooking.The instrumentsusedinthefirststageareincompatiblewiththetheorypositedinthe secondstage.Iflaggedinflationandcommoditypricesmatterforinflation,thenwhy aretheyomittedfromtheNKPCinflationequation? 4.5ConstraintsontheFormationofExpectations Recentresearchhasrevivedthediscussionofbarrierstotheformationof expectations.Aswehaveseen,theoriginalformulationsofFriedman,Phelps,and Lucaswerebasedoninformationbarriersthatpreventedonesetofagents(Friedmans workers)orallagents(Phelpsdesertislandresidents)fromhavingaccessto governmentdataonincome,output,money,andpricesthatarereleasedfrequentlyat zerocosttoallagentsintheeconomy.Thatliteraturewasflawedbecauseitplacedthe informationbarriersinthewrongplace,inaninabilitytoperceivecostlessmacro informationinsteadofwheretheinformationbarriersreallyexist,atthemicrolevelof costsandsupplierproducerrelationships. Producersoffinalgoodsareunabletoperceivecostincreasesofcrudeand intermediatematerialsthatmaybeinthepipeline,andtheyhavenochoicebuttowait untiltheyreceivenotificationofactualcostchanges(withtheexceptionofcrude materialslikeoilwherepricesaredeterminedinpublicauctionmarkets).This approachbasedonsupplierproducerarrangementswasintroducedinBlanchard(1987) andwaschristenedtheinputoutputapproachinGordon(1990),whosuggestsafour cellmatrixofinformationbarriersofsupplyanddemandshocksatboththemacroand

28

microlevel.Afundamentalsourceofpersistenceisnotjustexplicitwagecontractsas analyzedbyTaylor,butalsoexplicitorimplicitpricecontractsbetweensuppliersand producersoffinalgoods.Evenwithoutcontracts,persistenceandinertiaareintroduced bylagsbetweenpricechangesofcrudematerials,intermediategoods,andfinalgoods. Forsomegoods,e.g.,carsoraircraft,thereareliterallythousandsofseparate intermediategoods,andmostofthesearemadeupoffurtherlayersofintermediate goods. Therecentliteraturehaslargelyignoredthemicrouncertaintyembodiedinthe inputoutputapproachandinsteadhasattemptedtofindcredibleexplanationsfor imperfectmacroinformation.Oneapproachisthatagentstaketimetolearnaboutthe structureoftheeconomy(seeOrphanidesandWilliams,2007).Thisinformationbarrier isconsistentwiththetriangleapproach,inwhichchangesintheTVNAIRUarenot observedinrealtimebutonlyafterthefact,asarechangesincoefficientsonthePC slopeorthecoefficientsonsuchsupplyshocksasoilprices. Asecondbarriermaybeimperfectinformationregardingthegoalsofthecentral bank(see,amongothers,Kiley,2007).ClearlyintheUScontexttheFedhaschanged goalsseveraltimes,andthisbecameevidentonlyafterthefact.TheVolckerpolicyshift in197980waswidelynoticedatthetime,buttherewasnohistoricalantecedentto allowpredictionsofitsconsequences.Likewise,studiesoftheTaylorRuleindicatethat theFedshiftedaround1990fromapolicythatmainlyrespondedtoinflationtoapolicy thatmainlyrespondedtotheoutputgap,andnoempiricalTaylorrulecanexplainwhy theFederalFundsratewassolowin200104. Thethirdbarrierconsistsofcostsorconstraintsoninformationacquisitionand processing.Oneversionofthisapproachemphasizescostsofobtaininginformationthat leadtoinfrequentadjustmentsinexpectations(Reis,2006).Anotherapproach(seeSims, 2006)iscalledrationalinattentionandalsoemphasizesconstraintsoninformation processingcapabilities.However,allofthesebarriersconcernconstraintsontheability ofprivateagentstoadjusttheirexpectationsaccuratelytoreflectthecurrentstanceof monetarypolicyandanticipatedfuturechangesinpolicy,andnonereflectanyofthe sourcesofpersistenceandinertia,particularlylackofinformationatthemicrolevelof theinputoutputtable.Rationalinattentionmakessenseatthemicrolevel,when translatedintotheminimizationofmanagerialcostbyavoidingdailydeliberations aboutpricechangesrequiredbychangesinsuppliercostsandinsteadbymaking decisionsinfrequently. 4.6WhichModelAppliestoWhichEpisodes? ThissurveyhascontrastedtheinertiaboundtriangleapproachtoexplainingUS inflationwithalternativeframeworksinwhichtheexpectationsofprivateagentscan

29

jumpinresponsetoperceivedchangesinmonetarypolicy.Whichmodelbestdescribes whichhistoricalsituations?Asindicatedabove,themutualinterplaybetweenpolicy decisionsandexpectationsformationisessentialtounderstandingepisodesofrapid inflation,includingSargents(1982)endsoffourbiginflations.Thisapproachisinfact essentialtoanunderstandingoftheinflationprocessinanynationwhichhas experiencedhighinflationvolatilityinthepastduetoshiftsinpolicy(ascontrastedwith theinfluenceofsupplyshocks).AprimeexamplewouldbeacountrylikeArgentinain whichprivateagentsknowthatthegovernmentsabilitytorestrainmonetarygrowth dependsonfiscaldecisionsmadeatthelevelofstatesandlocalities. Relativelylittleresearchhasbeendonetoestablishadividinglinebetween situationssuitableforanalysiswiththepolicyexpectationsgameapproachvs.the inertiaboundtriangleapproach.Theconvergenceofinflationrateswithinthe EuropeanMonetaryUnionbetween1980and1998providesanotherexampleinwhich aninertiadominatedPCisinadequate,ascountrieswithsimilarunemploymentrates experiencedverydifferenttimepathsofinflation.Afterexperiencinginflationratesof over20to25percentinthemid1970s,ItalyandtheUKconvergedtolowsingledigitsof inflation,andanexplanationofthisconvergencerequiresamodelinwhichagents formedexpectationsbasedinpartonthemonetarypolicyoftheBundesbank,notjust thatoftheirownnationalcentralbank. 21 AnotherissueinextendingthePCframeworktofitthepostwarEuropean experienceisthequestionofwhetherthestandardPCrelationbetweentheinflationrate andthelevelofunemploymentneedstobesupplementedbyahysteresismechanism betweentheinflationrateandthechangeofunemployment.RecentlyBall(2008)has suggestedthatthehysteresisidea,afterlanguishingsinceitsinventionbyBlanchardand Summers(1986),shouldberevived.Someversionsofhysteresisimplythatinflation dependsnotonthelevelofunemploymentbutonitsrateofchange,thatancientidea supportedintheresultsofbothFisher(1926)andPhillips(1958)andincorporatedinthe trianglemodelspecification. Theempiricalresultspresentedinpart5belowsuggestthatthetrianglemodel, whichcombinesdemandandsupplyshockswithinertia,doesamuchbetterjobin explainingpostwarUSinflationthantheNKPCapproachthatomitslagsandsupply shocks.However,howfarbackcanthetriangletypePCspecificationbepushedinUS data?SamuelsonandSolow(1960)hadalreadynoticedthattheAmericanPC relationshipdoesnotworkintheGreatDepressionandduringthetwoWorldWars. AquantitativeanswertothisquestionwasprovidedbyGordon(1982a)inauniqueset ofinterpolatedquarterlydataextendingbackto1892.Hisresults(Table3)estimatePC equationsfor18921929,192953,and195480,inaframeworkwhichallowstheinflation
21.SeeDelBocaetal.(2008)forawiderangingeconometricassessmentoftheinflationrateof theItalianlirafrom1861to1998.TheyconcludethatItalyhashadaconventionalinflation outputtradeoffonlyduringtimesoflowinflationandstableaggregatesupply.

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ratetodependnotjustontheleveloftheoutputgap,butonchangesinexpectedand unexpectednominalGDP,laggedinflation,andaseriesofdummyvariables. Gordonsresultssuggestthatpriorto1954thereweresubstantialshiftsinthe AmericanPCprocessthatareconsistentwitharoleforaninterplaybetweenthe expectationsofprivateagentsandperceivedchangesinpolicyandthemacroeconomic environmentmoregenerally.ThePCrelation,intheformofthecoefficientonthe outputgap,hasroughlythesamecoefficientbefore1929asafter1954butiszeroduring themiddleperiod.Inallthreeperiodstheanticipatedandunanticipatedchangein nominalGDPishighlysignificant,andthisrateofchangeeffectdominatesthe explanationofinflationinthemiddleperiodwhenthePCrelationshipisabsent(seealso Romer1996and1999forananalysisofpricechangesinthe1930s). Theroleofpolicyinshiftingtheinflationrate(whetherthisisperceivedas workingthroughexpectationsornot)isevidentinlargeshiftcoefficientsontheimpact ofnominalGDPchangesoninflationinWorldWarI,andinlargenegativedummy variablesforpricecontrolsinWorldWarsIandII,theKoreanWar,andthe197174 Nixonepisode,aswellasalargepositivecoefficientfortheNewDealsNRA. 22

5.

TheNewKeynesianandTrianglePhillipsCurves:Specification, Estimates,andSimulations

WhatdifferencedoesitmakeifweexplainUSinflationusingthemainstream trianglemodelortheNKPC?WenowturntothedetailedspecificationoftheNKPC andtrianglealternatives.ThenweexaminetheirperformanceinUSdataspanning 19622007.

5.1TheNKPCModel AcentralchallengetotheNKPCapproachistofindaproxyfortheforward lookingexpectationsterminequation(8)above(Etpt+1).Surprisingly,thereislittle discussionintheliteratureofthisaspect,ortheimplicationsoftheusualsolution,which istouseinstrumentalvariablesortwostageleastsquares(2SLS)toestimate(8).The followingtreatmentisconsistentbyincludinginthefirststageonlythevariablesthat arepartofthebasictheoryinthesecondstage.Thefirststageequationtobeincluded

22.Allfourpricecontroldummyvariables,aswellastheNRAdummy,areenteredintheform ofoneffectssummingto1.0followedbyoffeffectssummingto1.0,implyingnopermanent impactofthecontrols.Thecoefficientsonthesedummyvariablesmeasurethecumulative impactofthecontrolsindisplacingthepricelevelpriortothereversesnapbackeffect.

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inthe2SLSestimationexplainsexpectedfutureinflationbyrecentlagsofinflationand bythecurrentunemploymentgap: Etpt+1=

p
i=1

i ti

+(UtU*t).

(10)

Whenthefirststageequation(10)issubstitutedintothesecondstageequation(8),we obtainthereducedform pt="

p
i= 1

i ti

+("N+$)(UtU*t)+et(11)

ThusinpracticetheNKPCissimplyaregressionoftheinflationrateonafewlagsof inflationandtheunemploymentgap.WehavealreadycitedFuhrer(1997)aspointing outthattheonlysenseinwhichmodelsincludingfutureexpectationsdifferfrompurely backwardlookingmodelsisthattheyplacerestrictionsonthecoefficientsofthe backwardlookingvariables,asin(11).TheprocedureofGalandGertler(1999)and manyothersofaddingadditionalvariableslikecommoditypricesandwagechangesto thefirststageequationisentirelyadhoc,aspointedoutbyRuddWhelan(2005a,2005b) becauseanyrelevanceofthesevariablestotheforecastingoffutureinflationis inconsistentwiththebasicsecondstageNKPCinflationmodelofequation(8)which omitstheseadditionalvariables. TheRoberts(2006)versionoftheNKPCisofparticularinteresthere,becauseof hisfindingthattheslopeofthePChasdeclinedbymorethanhalfsincethemid1980s. RobertsdescribeshisequationasareducedformNKPCandindeeditisidenticalto equation(11)abovewithtwodifferences:theNAIRUisassumedtobeconstant,andthe sumofcoefficientsonlaggedinflationisassumedtobeunity.ThustheRoberts(2006, equation2,p.199)versionof(11)is: p t=

p
i= 1

i ti

++$Ut+et(12)

wheretheimpliedconstantNAIRUis/.

5.2TheTriangleModelofInflationandtheRoleofDemandandSupplyShocks

Theinflationequationusedinthispaperisalmostidenticaltothatdeveloped25 yearsago(Gordon,1982b).Whentheinfluenceofdemandisproxiedbythe unemploymentgap,thetrianglemodelcanbewrittenasfollows,whichisidenticalto (7)aboveexceptfortheintroductionoflags:Thisgeneralframeworkcanbewrittenas: pt=a(L)pt1+b(L)(UtUNt)+c(L)zt+et,(13)

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 Asbeforelowercaselettersdesignatefirstdifferencesoflogarithms,uppercaseletters designatelogarithmsoflevels,andLisapolynomialinthelagoperator. 23 AsintheNKPCandRobertsapproaches,thedependentvariableptisthe inflationrate.Inertiaisconveyedbyaseriesoflagsontheinflationrate(pt1).Theterm ztisavectorofsupplyshockvariables(normalizedsothatzt=0indicatesanabsenceof supplyshocks),andetisaseriallyuncorrelatederrorterm.Distinguishingfeaturesin theimplementationofthismodelincludeunusuallylonglagsonthedependent variable,andasetofsupplyshockvariablesthatareuniformlydefinedsothatazero valueindicatesnoupwardordownwardpressureoninflation.Currentandlagged valuesoftheunemploymentgapserveasaproxyfortheinfluenceofdemand,where theunemploymentgapisdefinedasthedifferencebetweentheactualrateof unemploymentandtheNAIRU,andtheNAIRUisallowedtovaryovertime.This specificationpredictssteadyinflationwhentheunemploymentgapandthesupply shocktermsareallzero,andhenceitisalwaysestimatedwithoutaconstantterm. Theestimationofthetimevarying(TV)NAIRUcombinestheaboveinflation equation(12)withasecondequationthatexplicitlyallowstheNAIRUtovarywithtime: UNt=UNt1+t,Et=0,var(t)=2(14) Inthisformulation,thedisturbancetermtinthesecondequationisserially uncorrelatedandisuncorrelatedwithet.Whenitsstandarddeviation=0,thenthe naturalrateisconstant,andwhenispositive,themodelallowstheNAIRUtovaryby alimitedamounteachquarter.IfnolimitwereplacedonthevarianceoftheNAIRU, thentheTVNAIRUwouldjumpupanddownandsoakupalltheresidualvariationin theinflationequation(13). 24 Inpracticethesmoothnesscriterionischosentoavoid negativelycorrelatedzigzagsintheestimatedNAIRU,tobeconsistentwithFriedmans original(1968)ideaoftheNAIRUasslowlychanginginresponsetounderlying microeconomicstructuralfactors. ThetriangleapproachdiffersfromtheNKPCandRobertsapproachesby includinglonglagsonthedependentvariable,additionallagsontheunemployment gapthatincorporatearateofchangeeffect,andexplicitvariablestorepresentthe
23.ThistriangleorthreetermPCequation,witheachtermincludinglagsandalagoperator, wasintroducedinGordonKing(1982,equation13).Thenotationhasbeenusedbymany authorsinthemainstreamleftforktradition,mostrecentlybyBlinderRudd(2008, unnumberedequation,p.73) 24.ThismethodofestimatingtheTVNAIRUwasintroducedinsimultaneouspapersbyGordon (1997)andStaigerStockWatson(1997).

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supplyshocks(theztvariablesin(13)above),namelythechangeintherelativepriceof nonfoodnonoilimports,theeffectoninflationofchangesintherelativepriceoffood andenergy,thechangeinthetrendrateofproductivitygrowth,anddummyvariables fortheeffectofthe197174Nixonerapricecontrols. 25 5.3EstimatingtheTVNAIRU ThetimevaryingNAIRUisestimatedsimultaneouslywiththeinflationequation (12)above.Foreachsetofdependentvariablesandexplanatoryvariables,thereisa differentTVNAIRU.Forinstance,whensupplyshockvariablesareomitted,theTV NAIRUsoarsto8percentandaboveinthemid1970s,sincethisistheonlywaythe inflationequationcanexplainwhyinflationwassohighinthe1970s.However,when thefullsetofsupplyshocksisincludedintheinflationequation,theTVNAIRUisquite stable,shownbythedashedlineplottedinFigure5,remainingwithintherangeof5.7 and6.5percentovertheperiodbetween1962and1988. Beginninginthelate1980s,theTVNAIRUdriftsdownwardsuntilitreaches5.3 percentin1998,andthenitdisplaysafurtherdipin200406to4.8percent.One hypothesistobeexploredbelowisthattheRobertsNKPCimplementationreachesthe conclusionthatthePhillipscurvehasflattenedbecausetheNAIRUisforcedtobe constant,andthatadeclineintheTVNAIRUisanalternativetoaflatterPCin explainingwhyinflationhasbeenrelativelywellbehavedinthepast20years. y SomeoftheNKPCliteratureestimatestheTVNAIRUbydirectlyapplyinganH Pfiltertothetimeseriesoftheunemploymentrate.26 AsshowninFigure5usingthe traditionalHPparameterof1600,thisdirectapproachtoestimatingtheTVNAIRU resultsinanunexplainedincreaseintheTVNAIRUfrom3.9percentin1968to8.3 percentin1985,whereasthetriangleapproachhasnosuchunexplainedincrease

25.Therelativeimportpricevariableisdefinedastherateofchangeofthenonfoodnonoil importdeflatorminustherateofchangeofthecorePCEdeflator.Therelativefoodenergy variableisdefinedasthedifferencebetweentheratesofchangeoftheoverallPCEdeflatorand thecorePCEdeflator.TheNixoncontrolvariablesandthelaglengths(shownexplicitlyinTable 1)remainthesameasoriginallyspecifiedinGordon(1982b).Theproductivityvariableisthe8 quarterchangeinaaHodrickPrescottfilteredtrendofthechangeinnonfarmprivatebusiness outputperhour(using6400astheHPsmoothnessparameter). 26.InsubsequentworkStaiger,Stock,andWatson(2001)andStockWatson(2007)abandoned theattempttoestimatetheTVNAIRUasabyproductoftheinflationequation,andBlinder Rudd(2008)followtheirlead.NowtheyestimatetheNAIRUasatrendontheactual unemploymentrate,takingnoaccountoftheroleofsupplyshocksinmakingthistrend unusuallyhighin197475and198182orunusuallylowin19972000.Asaresulttheirversionof theunemploymentgap(UUN)greatlyunderstatesthesizeofthatgapanditsinfluenceon inflationduringthekeysupplyshockepisodes.

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becauseofitsintroductionofexplicitsupplyshockvariables. 27 IncontrasttheRoberts implementationoftheNKPCforcestheNAIRUtobeconstantatanestimated7.0 percent. Howmuchdifferencedotheexplicitsupplyshockvariablesmakeinthe predictionsofthetrianglespecification?Figure6displayspredictionsmadewiththe actualsupplyshockvariablesandwiththesupplyshockvariableszeroedout(butwith theothervariables,includingtheunemploymentgap,takingtheirhistoricalvaluesand estimatedcoefficients).Evidentlythesupplyshockvariablesexplainallofthetwin peaksofinflationinthe197381period,andinadditiontheyexplainmorethanhalfof theVolckerdisinflation(predictedinflationdropsby7percentagepointsbetween 1980:Q1and1985:Q1whensupplyshocksareincludedbutbyonly3percentagepoints whensupplyshocksareexcluded).Noticealsothatwithout(beneficial)supplyshocks, theinfluenceoflowunemploymentwouldhavecausedinflationtoriseby1.3 percentagepointsbetween1994and2001,whereaswithsupplyshocksinflationis predictedtoberoughlyconstant. 5.4RobertsNKPCvs.Triangle:CoefficientsandSimulationPerformance Wenextturntotheestimatedcoefficients,goodnessoffit,andsimulation performanceoftheRobertsNKPCandtrianglePCspecifications.Table1displaysthe estimatedsumsofcoefficientsandtheirsignificancelevelsforboththeRobertsNKPC andtrianglespecificationsforequationsinwhichthedependentvariableisthequarterly changeintheheadlinePCEdeflator.Inbothspecificationsthesumofcoefficientson thelaggedinflationtermsisveryclosetounity,asinpreviousresearch. 28 Thesumof theunemploymentgapvariablesinthetriangleapproachisaround0.6,whichis consistentwithastylizedfactfirstnoticedbySamuelsonandSolow(1960)thattheslope oftheshortrunPhillipscurveisroughlyminusonehalf.WhyistheRobertsNKPC unemploymentcoefficientlowerthaninthetrianglespecification?Theexcludedsupply shockvariablesarepositivelycorrelatedwithinflationandpositivelycorrelatedwiththe unemploymentgap,andsotheomissionofthesesupplyshockvariablescausesthe negativecoefficientontheunemploymentgaptobebiasedtowardzero.Wenotethat thesumofsquaredresiduals(SSR)forthetrianglemodelisbarelyonequarterthatof theRobertsNKPCspecification.
27.BasisthaNelson(2007)areamongthoseauthorswhoexcludeexplicitsupplyshockvariables fromtheirequationsandderiveestimatesoftheTVNAIRUthatareextremelyhigh,e.g.,8 percentin1975and10percentin1981(2007,p.509,Figure6). 28.Theinclusionoflags1324(yearsfourthroughsix)inanexclusiontestisstronglysignificant atthe0.00confidencelevel.AsstatedinthenotestoTable1,weconserveondegreesoffreedom byincludingsixsuccessivefourquartermovingaveragesofthelaggeddependentvariableat lags1,5,9,13,17,and21,ratherthanincludingall24lagsseparately.

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 Theexplicitsupplyshockvariablesinthetrianglemodelareallhighlysignificant andhavethecorrectsigns;exceptfortheproductivitytrendvariable,alloftheseenter exactlyasspecifiedin1982andthustheirsignificancehasnotbeendiminishedbyan extra25yearsofdata.Thechangeintherelativeimportpriceeffecthasahighly significantcoefficientof0.06. 29 Thefoodenergyeffecthasacoefficientof0.89,closeto theexpectedvalueof1.0.Theproductivitytrendvariablehastheexpectednegative coefficientandhelpstoexplainwhyinflationacceleratedin196580andwassowell behavedin19952000.TheNixoncontrolcoefficientsasinpreviousresearchindicatea significantimpactofthecontrolsinholdingdowninflationbyacumulative1.6percent in197172andboostinginflationby1.8percentin197475. Ratherthanrelyingontheusualstatisticalmeasuresofgoodnessoffit,a dynamicmodelheavilydependentonthecontributionofthelaggeddependentvariable isbesttestedbythetechniqueofdynamicsimulations.Thesegeneratethepredictionsof theequationwiththelaggeddependentvariablegeneratedendogenouslyratherthan takingtheactualvaluesoflaggedinflation.Torunsuchsimulations,thesampleperiod istruncatedtenyearsbeforetheendofthedatainterval,andtheestimatedcoefficients through1997:Q4areusedtosimulatetheperformanceoftheequationfor19982007, generatingthelaggeddependentvariablesendogenously.Sincethesimulationhasno informationontheactualvalueoftheinflationrate,thereisnothingtokeepthe simulatedinflationratefromdriftingawayfromtheactualrate.Thesesimulationshave beencriticizedbecausetheyusetheactualvaluesoftheexplanatoryvariablesotherthan laggedinflation,butthisisnotanexerciseinforecastingbutratherindetermining whetheraparticularsetofvariablesandlagsaddstotheexplanatorypowerofthe equation. ThebottomsectionofTable1displaysresultsofadynamicsimulationfor 1998:Q1to2007:Q4basedonasampleperiodthatendsin1997:Q4.Twostatisticson simulationerrorsareprovided,themeanerror(ME)andtherootmeansquarederror (RMSE).Thesimulatedvaluesofinflationinthetrianglemodelareclosetotheactual values,withameanerrorover40quartersofonly0.29,meaningthatovertheforty quarterstheactualinflationrateonaverageis0.29percentagepointshigherthanthe predictedvalue.However,themeanerrorfortheRobertsNKPCmodelisahuge 2.75,andasdisplayedinFigure7,thiserrorreflectsthatmodelswildoverprediction thattheinflationrateshouldhavereachednearly8percentbylate2007.TheRMSEof thetrianglesimulationisabitabovetheSEEforthe19621997sampleperiod,whereas fortheRobertsNKPCmodeltheRMSEisalmostthreetimesaslarge. TheRobertsNKPCandtriangleresultsagreeononlyoneaspectoftheinflation

29.ThiscanbecomparedtoanimportshareinnominalGDPof10percentatthemidpointofthe sampleperiodin1985.

36

process,thatthesumofcoefficientsonthelaggedinflationtermsisalwaysverycloseto unity.However,theRobertscoefficientsontheunemploymentratearemuchlower thanthetrianglecoefficientsontheunemploymentgap.Thisisanartifactofthe exclusionrestrictionsintheRobertsapproachwhicharestatisticallyrejectedinthe triangleapproach. ThetrianglemodeloutperformstheRoberts/NKPCmodelbyseveralordersof magnitude,asdisplayedinTable1andFigure7.Thisraisesaquestioncentraltofuture researchontheUSPhillipscurve:whatarethecrucialdifferencesthatcontributetothe superiorperformanceofthetrianglemodel?Thethreekeydifferencesaretheinclusion inthetrianglemodeloflongerlagsonbothinflationandtheunemploymentgap,the inclusionofexplicitsupplyshockvariables,andtheallowanceforatimevarying(TV) NAIRUinplaceoftheRobertsNKPCassumptionofafixedNAIRU.IntheAppendix wequantifytheroleofthesedifferences,takingadvantageofthefactthattheRoberts NKPCmodelisfullynestedinaversionofthetrianglemodelthatassumesaconstant NAIRU.EachexclusionrestrictionintheRobertsmodelcanbetestedbystandard statisticalexclusioncriteria,andeveryoneoftheRobertsNKPCexclusioncriteriais rejectedathighlevelsofstatisticalsignificance. 30 5.5HasthePCSlopeBecomeFlatter? TheNKPCresearchofRobertsandothershasconcludedthatthePhillipsCurve hasbecomeflatteroverthepastseveraldecades.Yetwehaveseenthateveryaspectof theRobertsNKPCspecificationisrejectedathighlevelsofstatisticalsignificance. HasthePhillipsCurveflattened?TheRobertsNKPCspecificationsaysyes andthetrianglespecificationsaysno.Figure8evaluateschangesincoefficientsby Robertsownpreferredmethod(2006,Figure2,p.202),rollingregressionsthatshiftthe sampleperiodoftheregressionthroughtimeinordertorevealchangesincoefficients. ThenumberofquartersinourbasicresultsinTable1is184(1962:Q1to2007:Q4),and wecutthisroughlyinhalfto90quartersandrunrolling90quarterregressionswhich alternativelystartineachquarterfrom1962:Q1to1985:Q3. AsshowninFigure8,theRobertsNKPCunemploymentcoefficientrisesfrom 0.17in1962toapeakvalueof0.41in1974,andthendeclinesbacktoroughlyzeroin 198284.ThisappearstosupporthisbasicconclusionthatthePhillipsCurvehas flattened.Yetthetrianglemodelrevealsnoevidenceofadeclineintheslopeofthe Phillipscurve.ThePhillipscurvebasedonthetrianglemodelhasaroughlystablePC slopeofabout0.6to0.7from1963to1977,andthenthesloperisestowardabout0.7to

30.DewBecker(2006)haspreviouslytracedthestatisticalsignificanceofstrippeddownPhillips CurvesandreachedconclusionsthataresimilartothosearrayedinAppendixTableA1.

37

about0.9inthesimulationsstartingin1982,thendriftsbackto0.7inthefinalyear.As indicatedabove,theNKPCslopeestimateisbiasedtowardzerobydifferingamountsin eachperiod,duetotheomissionofsupplyshocks. 5.6HastheImpactofSupplyShocksBecomeLessImportant? Hooker(1996)wasamongthefirsttonoticethatthemacroeconomicimpactofoil shocksbecamesmalleratsomepointbetweenthemid1970sandearly1980s.Sincehis workasubstantialliteraturehasarisentodebatethesourcesofthedeclineintheimpact ofoilpricesonrealoutputand/orinflation.Themostobviouscauseofthedecreased macroeconomicimpactofoiloriginatesintheshrinkinginputofenergyinGDP,down byhalfsince1969. 31 Kilian(2008)providesasetofreasonsthatgobeyondthedeclining inputshareofenergy.Partoftheanswerliesintheroleofglobaldemandincausing muchoftherecent200408riseinoilprices;ademanddrivenincreaseinoilpricesmay raiseratherthanreducerealGDPaswouldoccurinthecaseofasupplydisruption. BlanchardGal(2007)gomoredeeplyintothesourcesofthedeclining macroeconomicimportanceofoilbeyonditsshrinkinginputshare.Theirfirstreasonis thatthe1970soilshockshadabigimpactbecausetheywereaccompaniedbyother significantshocksthatallhadtheeffectofraisingtherateofinflationandreducing output.Theseothershocks,embeddedinthetriangleinflationequationsincethe beginning,includeadversefoodpriceshocks,thedepreciationofthedollarafterthe breakdownofBrettonWoods,andtheunwindingoftheNixonerapricecontrols.The 200408riseinoilpriceshadasmallerimpactbecauseitwasnotaccompaniedasinthe 1970sbytheseotheradverseshocks.Therewasanincreaseintherealpriceoffoodonly in200708,andthepost2002declineinthedollarwasnotsufficienttocauseany sustainedincreaseintherelativepriceofimports. BlanchardGalalsoconsidertwoadditionalfactorsthatmayhavereducedoils impact,adecreaseintheextentofrealwagerigidityandtheincreasedcredibilityof monetarypolicy.Usingsurveydataonexpectedinflation,theyshowasharply diminishedresponseofexpectationstoagivensizeofoilshockafterthemid1980s, whichtheyattributetoincreasedcredibility. Doesthetrianglemodelconfirmareducedmacroeconomicroleforoilshocks? Partofoilsimpactisdisguisedinthetrianglespecification,whichentersnotthechange intherealpriceofoil,butratherthefoodenergyeffectdefinedasthedifference betweenheadlineandcoreinflation.ThusthedecliningshareofenergyinputinGDP wouldcauseareducedresponseofthefoodenergyeffecttoanygivenchangeinthereal

31.BlinderRudd(2008,Figure19)plotaratioofBTUstorealGDPthatdeclinesfrom18in1969 to8.7in2007.

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priceofoil,notachangeinthecoefficientonthefoodenergyeffectinthetriangle inflationequationitself. However,itdoesappearthatthecoefficientonthefoodenergyeffecthas declined,assuggestedbytheotherliteraturesurveyedinthissection.Figure9plotsthe sumofcoefficientsonthefoodenergyeffectinrollingregressionscomputedbythe sametechniqueandforthesametimeperiodasfortheunemploymentcoefficient alreadydisplayedinFigure8.Twolinesareshown.Thefirstshowschangesinthe foodenergysumofcoefficientsintheequationforheadlineinflation,thesameasTable 1.Incontrasttoacoefficientsumof0.89whenthatsumisheldconstantoverthefull 19622007periodasinTable1,Figure9showsthatthesumofcoefficientsisatorabove 1.0in90quarterregressionsstartingin1962through1980,andthenthesumdeclinesto about0.6inthefinal90quarterregressionestimatedfor1985:Q32007:Q4.Thesecond lineshowsasimilardeclineinthefoodenergyeffectinthecoreinflationequation,from anaverageof0.72for90quarterregressionsbeginningin1962through1980downto only0.3forthefinal90quarterregression. 32 Thereislikelytobeaninterplaybetweenshiftsincoefficientsandtheestimated TVNAIRUdisplayedinFigure5.Forinstance,thesuddendeclineintheTVNAIRU from5.0to4.5percentin200607maybeanartifactoftheassumedfixityofthefood energycoefficient.Ifthesumofcoefficientsonthefoodenergyeffectin200607were allowedtobesmaller,therewouldbelessofapuzzleastowhyinflationwassolow duringthatperiodandhencenoreasonfortheestimationtoforceadeclineinthe NAIRU.IncurrentresearchIamlookingmorecloselyatchangesovertimeinallthe setsofcoefficientsinthespecificationofTable1andtheirimplicationforpostsample simulationperformanceandthetimeseriesbehavioroftheTVNAIRU.

6.

Conclusion

Thepapermakesseveraluniquecontributions.Itcontraststheconsensushistory ofthePCbefore1975withthebifurcatedsplitinPCresearchsince1975.Theevolution ofPCdoctrinebefore1975iswidelyacceptedandnolongerelicitsmuchdebate.The discoverybyPhillipsandhisdisciplesSamuelsonSolowofaninverserelationship betweeninflationandunemploymentbrieflysuggestedanexploitablepolicytradeoff thatwasdestroyedbytheFriedmanPhelpsnaturalratehypothesisofthelate1960s. Exploitabletradeoffswereout,andlongrunneutralitywasin(ithadneverdisappeared

32.ThecoreinflationequationisspecifiedexactlyastheheadlineequationinTable1,withthe exceptionofthefoodenergyeffect.Toallowforlongerlagsintheimpactofenergyoncore inflation,thefoodenergyeffectismeasuredasthefourquartermovingaverageofthedifference betweenheadlineandcoreinflationandisenteredatlags1,5,and9.

39

inmanyenvironments,includingLatinAmericaandtheUniversityofChicago).The econometricmodelsdevelopedinthe1960stosupportthepolicytradeoffwererejected bothempiricallyandlogicallybySargentstrenchantidentificationargument. Debatesintheearly1970scenteredonthemodelsinwhichFriedmanandPhelps hadembeddedthenaturalratehypothesis,andparticularlytheassumptionofarbitrary barriersthatpreventedindividualworkersoragentsingeneralfromlearningthevalues ofmacrodataoutput,money,andpricesprovidedcostlesslybythegovernment. Therewasalsocontroversyabouttheimplicationsofthefurtherdevelopmentofthe FriedmanPhelpsparadigmbyLucas,whointroducedrationalexpectationsinto macroeconomics.TheLucasmodelimpliedthepolicyineffectivenessproposition, whichheldthatanticipatedchangesinmoneyhadnoeffectonoutputandwereentirely reflectedinpricechanges.Empiricalworkrejectedthisframework,showingthat monetarysurpriseshadlittleeffectonoutput,wereincapableofexplainingtheserial correlationofoutput,andwereinconsistentwiththepersistenceofinflation. After1975thePCliteraturebifurcatedintotwolinesofresearchwhichsincethen havecommunicatedlittlewitheachother.Alongtheleftforkintheroad,thePCwas revivedbyimportingmicrodemandandsupplyanalysisintomacroeconomics.There wasnoassumptionthatunemploymentandinflationarenegativelycorrelated. Demandshockscreateaninitialandtemporarynegativecorrelation,andsupplyshocks createaninitialpositivecorrelationthatthenevolvesaccordingtothepolicyresponse. Asearlyas1975thetheoreticalliteratureonpolicyresponsestosupplyshockswas developedandshowedthatadversesupplyshocksforcepolicymakerstochoose betweenhigherinflation,loweroutput,oracombination.Bytheearly1980san econometricspecificationofthisADASframeworkwasavailablethatjoineddemand andsupplyshockswithlongrunneutralityandastrongroleforpersistenceandinertia. Animportantdifferencebetweenthemainstreamapproachandotherpost 1975developmentsisthattheroleofpastinflationisnotlimitedtotheformationof expectations,butalsoincludespurepersistenceduetofixeddurationwageandprice contracts,andlagsbetweenchangesinintermediategoodsandfinalproductprices. Inflationisdislodgedfromitspastinertialvaluesbydemandshocksproxiedbythe unemploymentoroutputgap,andexplicitsupplyshockvariablesincludingchangesin therelativepricesoffood,energy,imports,andtheroleofchangesintrendgrowthof productivity.Theeconometricimplementationofthisapproachissometimescalledthe trianglemodel,reflectingitsthreecornereddependenceondemand,supply,and inertia. After1975therightforkintheroadbuiltmodelsinwhichexpectationsarenot anchoredinbackwardlookingbehaviorbutcanjumpinresponsetocurrentand anticipatedchangesinpolicy.Importantelementsofthisliteratureincludepolicy credibility,modelsofthegameplayedbypolicymakersandprivateagentsforming

40

expectations,andtheNewKeynesianPhillipsCurve(NKPC)whichderivesaforward lookingPCfromalternativetheoriesofpricestickiness.Thecommonfeatureofthese theoriesistheabsenceofinertia,theexclusionofanyexplicitsupplyshockvariables,the abilityofexpectedinflationtojumpinresponsetonewinformation,andalternative barrierstoaccurateexpectationformationduetosuchfrictionsasrationalinattention. Whichpost1975approachisright?Modelsinwhichexpectationscanjumpin responsetopolicyareessentialtounderstandingSargents(1982)endsoffourbig inflationsandotherrelativelyrapidinflationsinnationswithahistoryofmonetary instability,e.g.,Argentina.Butthemainstream/triangleapproachistheright econometricframeworktounderstandtheevolutionofpostwarUSinflation.Thepaper teststhetriangleeconometricspecificationalongsideonerecentlypublishedversionof theNKPCapproach.Thelattercanbeshowntobenestedintheformermodelandto differbyexcludingparticularvariablesandlags,andthesedifferencesareallrejectedby testsofexclusionrestrictions.ThetrianglemodeloutperformstheNKPCvariantby ordersofmagnitude,notonlyinstandardgoodnessoffitstatistics,butalsoinpost sampledynamicsimulations.ThetriangleestimatesshowsthattheslopeofthePhillips curvehasnotbecomeappreciablyflatterinthepasttwodecades,aconclusionreached intheNKPCframeworkduetothespecificationerrorofomittingexplicitsupplyshock variables.Thetriangleestimatesdohoweverconfirmotherworkindicatingthatthe impactofoilshocksoninflationhasdiminished. Thustherearethreemaininterrelatedthemesinthispaperthathavenot previouslyreceivedsufficientattention.First,twoquitelegitimateresponses,theleft andrightforks,occurredafter1975tothechaoticstateofthePCliteratureatthattime. Second,eachresponseisimportantandhelpsusunderstandhowinflationbehaves, albeitindifferentenvironments.Third,thetwoapproachesneedtopaymoreattention toeachotherandtoengageinadialogueaboutwhichmodelsapplytowhichepisodes, andwhatfactorswouldmotivateashiftinrelevancebetweenthealternativemodels. Thispaperrepresentsastarttowardthatreconciliation.

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Appendix:TheTranslationMatrixbetweentheRoberts/NKPCandTriangle Specifications
WhichdifferencesmatterinexplainingthepoorperformanceoftheRobertsNKPC specificationinTable1andFigure7?InthisappendixwestartwiththeRobertsNKPC specificationandgraduallychange,stepbystep,tothetrianglespecification,allowing alternativelytheNAIRUtobeconstantandtovaryovertime.Ineverythingthat follows,thesampleperiodis1962:Q1to2007:Q4. AppendixTableA1providesthetranslationmatrixthatguidesusbetweenthe RobertsNKPCspecificationandthetrianglespecification. i Thereare24linesthatallow ustotracetheroleofeachspecificationdifference,andtheindividuallinesofalternative specificationareevaluatedbasednotjustontheSSRmeasureofgoodnessoffit,butalso onthepostsamplesimulationperformancein19982007basedoncoefficientestimates for19621997. WehavealreadyseeninTable1thattheperformanceoftheRobertsNKPC specificationforthePCEdeflatorisinferiortothatofthetrianglespecificationbyboth thecriterionofgoodnessoffit(SSR)andalsothecriterionofdynamicsimulation performance(MEandRMSE).InTableA1thebasicRobertsvariantisonline1andthe basictrianglevariantisonline21.Robertsline1andthetriangleline21haveSSRsof 244.0and64.6,exactlythesameasinTable1above. TableA1allowsthethreemaindifferencesbetweentheRoberts/NKPCandtriangle specificationstobeevaluated,stepbystep.Isthecrucialdifferencethelongerlags,the supplyshocks,theTVNAIRU,oraninteractionofthesedifferences? Inthe24linesofTableA1,thefirst12linesexcludesupplyshockvariablesandlines 1324includethem.ScanningdownthecolumnforSSR,wefindthatthevariantson lines1324includingsupplyshocksallhaveSSRsbelow100,whilemostoftheSSRs thatexcludesupplyshockshavevaluesabove200.Thusourfirstconclusionisthatthe exclusionofexplicitsupplyshocksintheRobertsNKPCresearchisthecentralreason foritsempiricalfailureeithertoexplainpostwarinflationortotracktheevolutionof inflationinpostsample19982007simulations.Thisfindingappliestoallprevious NKPCresearchwhichexcludesexplicitSSvariables. WhatdifferenceismadebylonglagsandbytheTVNAIRU?Whensupply shocksareomittedasinlines112ofTable3,thereislittledifferenceamongthe alternativevariantswhichyieldSSRsrangingfrom183.8to244.0.Simulationmean errors(ME)rangefrom2.04to2.75whentheNAIRUisfixed.MuchlowerMEsare obtainedwhentheNAIRUisallowedtovaryovertime.

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 Thesetofresultsthatincludesupplyshocksaredisplayedonlines13to24in TableA1.Whensupplyshocksareincludedbutlaglengthsareshort,asinlines1314, 1719,and22,thepostsamplesimulationerrorsareverylarge.Whensupplyshocksare included,thebestresultsareonlines1516withafixedNAIRUandonlines2021with aTVNAIRU.Longlagsonthedependentvariable(inflation)matterinthe specificationofaPCincludingsupplyshocks. TherightsectionofTableA1containsalargenumberofsignificancetestsonthe exclusionofvariableswhichareomittedintheRobertsNKPCspecificationand includedinthetrianglespecification.Startingonline3,evenwithoutsupplyshock variables,thesignificancevalueofexcludinglags924onthelaggeddependentvariable is0.01andonlags14oftheunemploymentgapis0.03.Throughoutlines112ofTable 3,welearnthatexcludingshortlags(e.g.,excludinglags58fromequationscontaining inflationlags14)isinsignificant,whereasexcludinglags924yieldshighlysignificant exclusiontests. Lines1324,whichallincludethefullsetofsupplyshockvariables,differonlyin thelengthoflagsincludedonthelaggeddependent(inflation)variableandonlagged unemployment,andalsoonwhethertheNAIRUisforcedtobefixedorisallowedto varyovertime.WecaninterpretthebottomhalfofTableA1bylookingatblocksof fourrows. Thefirstgroupoffourrows,13through16,shareincommontheinclusionof supplyshocks,theassumptionofafixedNAIRU,andalternativelagsonthedependent variable.Themeanerrorinthedynamicsimulationsfallsby80percentwhenlagsupto 24areincluded,andtheexclusionoflags924isrejectedata0.00significancevalue. Thesameresultoccursinlines2225whenwithatimevaryingNAIRUthesignificance oflonglagsonthedependentvariablearestronglysupportedatsignificancelevelsof 0.00.

43

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Figure 1. The Unemployment and Inflation Rates, Quarterly Data, 1960-2007

12

10

Unemployment Rate

Percent

Inflation Rate 2

0 1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

Source : Inflation rate is the four-quarter change in the headline PCE deflator.

Figure 2. Scatter Plot of the Unemployment and Inflation Rates, Quarterly Data, 1960-80
12

1975

10
1980

Inflation Rate (percent)

8
1974 1979

1970 1969 1972 1968 1967 1973

1978 1971

1976 1977

1966

1965 1960

1962 1964 1963

1961

0 0 1 2 3 4 5 6 7 8 9 10 Unemployment Rate (percent)

Figure 3. The Inflation Rate and the Percent Log Output Gap, Quarterly Data, 1960-2007
15

10 Inflation Rate 5 Percent 0 1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

-5 Log Output Gap -10

Figure 4. The Inflation Rate and Labor's Share in Domestic Net Factor Income, Quarterly Data, 1960-2007
12 76 75 10 74 Labor's Income Share (right scale) 8 Percent 73 Percent 72 6 71 4 70 69 2 Inflation Rate (left scale) 68 67 1965 1970 1975 1980 1985 1990 1995 2000 2005

0 1960

Figure 5. Actual Unemployment Rate vs. Time-Varying NAIRU, 19622007

11

10

Actual Unemployment
9

8 Percent

Unemployment Trend, HP1600

TV NAIRU
6

3 1962

1967

1972

1977

1982

1987

1992

1997

2002

2007

Figure 6. Predicted Inflation in Triangle Mode with and without Supply Shocks, 1962:Q1 to 2007:Q4
12

10

Predicted Inflation with Actual Shocks

6 Percent 4

Predicted Inflation with Shocks Suppressed

-2 1962

1967

1972

1977

1982

1987

1992

1997

2002

2007

Figure 7. Predicted and Simulated Values of Inflation from Triangle and NKPC Equations 1962:Q1 to 2007:Q4
12

10

NKPC Simulation
Percent 6

Actual Inflation

Triangle
0 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007

Figure 8. NKPC vs. Triangle Unemployment Coefficients in 90 Quarter Rolling Regressions from 1962:Q1 to 1985:Q3
0

-0.1

NKPC
-0.2

-0.3

-0.4

Triangle
-0.5

-0.6

-0.7

-0.8

-0.9

-1 1963

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

Figure 9. Sum of Coefficients on Food-Energy Effect in Headline and Core Triangle Inflation Equations, 90 Quarter Rolling Regressions from 1962:Q1 to 1985:Q3
1.6

1.4 Headline Inflation Equation 1.2

1 Percent 0.8 0.6 0.4 0.2 Core Inflation Equation

0 1963

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

TABLE1 EstimatedEquationsforQuarterlyChangesin thePCEDeflator,1962:Q1to2007:Q4

Roberts Variable Lags NKPC Triangle

Constant LaggedDependentVariable UnemploymentGap UnemploymentRate RelativePriceofImports FoodEnergyEffect ProductivityTrendChange NixonControlson NixonControlsoff R2 S.E.E S.S.R DynamicSimulation 1998:Q12007:Q4 MeanError RootMeanSquareError 1-24 1-4 0-4 0 1-4 0-4 15 0 0
a

1.16 ** 1.01 ** 0.95 ** -0.56 ** -0.17 * 0.06 ** 0.89 ** -0.95 ** -1.56 ** 1.78 ** 0.78 1.17 244.0 0.93 0.64 64.6

Note b -2.75 3.20 0.29 0.70

Notes: ** indicates significance at 1 percent, * at 5 percent a) Lagged dependent variable is entered as the four-quarter moving average for lags 1, 5, 9, 13, 17, and 21, respectively b) Dynamic simulations are based on regressions for the sample period 1962:Q1-1997:Q4 in which the coefficients on the lagged dependent variable are constrained to sum to unity.

AppendixTableA1 TransformationofPhilipsCurvefromRobertsNKPC(line1)toTriangle(line21),1962:Q12007:Q4
Regression Statistics Ulag InfLag 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 1 to 4 1 to 8 1 to 24 1 to 4 1 to 4 1 to 8 1 to 24 1 to 8 1 to 24 1 to 4 1 to 8 1 to 24 1 to 4 1 to 4 1 to 8 1 to 24 1 to 8 1 to 24 0 0 0 Fixedor Supply R2 SEE SSR ME Fixed Fixed Fixed Fixed No No No No No No No No No No No No Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes length TVNAIRU shocks Simulation Excludeinf Errors RM lags58 Sig SE FStat Level 1.11 0.35 2.18 0.01 2.81 0.03 0.55 0.70 1.71 0.05 0.61 0.66 2.21 0.01 18.20 0.00 0.52 0.72 3.09 0.00 1.22 0.31 0.84 0.50 4.84 0.00 0.30 0.88 3.85 0.00 17.39 0.00 18.31 0.00 23.85 0.00 16.79 0.00 17.31 0.00 17.12 0.00 23.66 0.00 30.70 0.00 16.18 0.00 18.81 0.00 23.88 0.00 Excludeinf lags924 Sig FStat Level ExcludeU lags14 FStat Lev el Exclude Supply Sig FStat Level

0.78 1.17 244.0 -2.75 3.20 0.78 1.17 237.9 -2.73 3.15 0.80 1.11 195.0 -2.04 2.41 0.78 1.16 238.5 -2.19 2.53 0.79 1.15 229.2 -2.27 2.68 0.79 1.13 224.8 0.79 1.14 222.0 0.80 1.10 188.7 0.79 1.14 225.6 0.26 1.43 0.36 1.46 0.15 1.33 0.03 1.33

1 5 9 13 17 21 0

0 to 4 Fixed 0 to 4 TV 0 to 4 TV 0 to4 TV

1 5 9 13 17 21 0 to 4 TV 0 to 4 Fixed 0 to 4 Fixed 0 0 0 Fixed Fixed Fixed Fixed

0.78 1.15 226.0 -2.11 2.53 0.81 1.09 183.8 -2.18 2.54 0.80 1.12 216.7 -2.23 2.56 0.90 0.78 100.3 -2.45 3.06 0.90 0.78 0.92 0.71 0.92 0.71 0.90 0.78 0.91 0.76 0.91 0.76 0.93 0.65 0.93 0.64 0.90 0.78 0.92 0.69 0.93 0.68 99.0 -2.60 3.15 73.8 -0.18 1.00 82.2 -0.24 0.97 97.3 -2.11 2.72 94.1 -1.14 1.47 92.1 -1.15 1.40 59.6 64.6 0.30 0.74 0.29 0.70

1 5 9 13 17 21 0 to 4 Fixed

1 5 9 13 17 21 0

0 to 4 Fixed 0 to 4 TV 0 to 4 TV 0 to 4 TV 0 to 4 Fixed 0 to 4 Fixed

1 5 9 13 17 21 0 to 4 TV

96.6 -2.23 2.77 67.2 -0.50 1.08 73.4 -0.56 1.06

1 5 9 13 17 21 0 to 4 Fixed