FRBSF Economic Letter
99-09; March 12, 1999
 Economic
Letter Index
Economic Activity and Inflation
This Letter reviews four papers on the relationship between
inflation and economic activity that were presented at a recent macroeconomics
workshop organized by the Federal Reserve Bank of San Francisco and the
Stanford Institute of Economic Policy Research. The papers focused on
the Phillips curve, named for A.W. Phillips (1958); he showed that a plot
of (wage) inflation against unemployment for the U.K. produced a downward-sloping
curve, indicating that higher unemployment was accompanied by lower inflation.
The nature of this relationship has been studied and debated extensively,
reflecting its importance for numerous policy issues. For instance, policymakers
would like to know how much unemployment would increase if they tried
to reduce inflation by some amount. This relationship also plays a key
role in forecasting inflation in many Keynesian models.
Does the Phillips curve always slope downwards?
Haldane and Quah begin by showing that 50 years of postwar U.K. data
do--at first glance--exhibit a negative relationship between unemployment
and inflation, much as Phillips found in data through 1957. However, they
then demonstrate that this relationship conceals two quite different relationships
that held during the pre-1980 and post-1980 subperiods. Before 1980, the
unemployment rate moved relatively little and was generally below 4%,
while the inflation rate was fairly volatile and appears to have been
centered around 10%. A plot of inflation against unemployment over that
period would produce a vertical Phillips curve. After 1980, unemployment
moved around more, ranging between 4% and 12%, while inflation varied
less than the prior period, remaining below 10% most of the time. Here,
the Phillips curve appears horizontal. Note that unemployment is higher
on average while inflation is lower in the second subsample than in the
first, which is why we get an apparently downward-sloping Phillips curve
for the overall postwar period.
Other data sets Haldane and Quah examined also reveal differing relationships
between inflation and unemployment. For instance, over periods that approximate
the length of the business cycle, U.S. data reveal a negative relationship
between the two variables, while U.K. data exhibit no such relationship.
Finding different relationships between unemployment and inflation in
different data sets suggests that the conventional downward-sloping Phillips
curve is not a fundamental economic relationship and prompts a search
for the features of the economy responsible for the changing patterns
observed in the data. In their theoretical work, the authors show how
differences in policymakers' beliefs about the economy can lead to differences
in the observed Phillips curve. First, they present a model economy where
it is optimal for fully informed policymakers to reduce the rate of inflation
when unemployment is low and to raise the rate of inflation when unemployment
is high. Intuitively, periods of low unemployment (for instance) make
it less costly to reduce inflation. However, while such behavior tends
to stabilize both output and inflation, the result is a Phillips curve
that is upward sloping! The authors then show that this prediction can
change if policymakers do not know exactly how the economy functions.
For instance, a conventionally sloped Phillips curve can emerge if policymakers
are mistaken about the nature of the tradeoff between inflation and unemployment.
According to the authors, the "mistakes" they focus on are
meant to describe the changing beliefs of the British authorities in the
postwar era. At first, monetary authorities probably believed that there
was a long-run tradeoff between inflation and unemployment. Later, they
realized that this belief was incorrect, but still believed there was
a fixed short-run tradeoff between inflation and unemployment which they
could exploit. More recently, they have abandoned this belief as well.
The authors show that these beliefs have different implications for the
behavior of output and inflation generated by their model, and that the
predictions from their model are consistent with some (but not all) of
the patterns observed in the data.
Learning about the tradeoff
Sargent's paper also emphasizes the role of changing beliefs and uses
these changes to explain variations in the U.S. inflation rate since the
1960s. A key feature of his paper is that these changes in policymakers'
beliefs occur because of their analysis of incoming data about the economy.
As in the Haldane and Quah paper, Sargent assumes that monetary policymakers
attempt to minimize fluctuations in inflation and unemployment around
some target levels. He further assumes that policymakers can control the
rate of inflation reasonably well, but they do not know exactly how variations
in the rate of inflation will affect the unemployment rate. More formally,
they do not know the "true" model. They try to learn the "truth" by statistically
estimating the relationship between inflation and unemployment--a Phillips
curve--using all the available data. They reestimate this relationship
each period when new data come in. Policymakers also believe that this
relationship tends to shift over time, so they employ estimation techniques
that de-emphasize older data. Finally, each period they use the latest
estimates of the Phillips curve to determine the optimal rate of inflation.
Typically (but not always), the Phillips curve estimated by policymakers
shows a tradeoff between inflation and unemployment, which tends to reflect
the tradeoff between surprise inflation and unemployment inherent in the
"true" model. (This kind of model will be described in more detail in
the discussion of the paper by Ireland below.) In an attempt to exploit
this tradeoff, policymakers tend to push the inflation rate to a relatively
high level.
However, Sargent's model economy does not settle down at this point.
The economy is subject to random shocks, so the shape of the estimated
Phillips curve keeps changing. (The assumption that older data get de-emphasized
is important here.) Eventually, the estimated Phillips curve appears vertical,
that is, the data suggest that there is no tradeoff between inflation
and unemployment. Optimizing policymakers then reduce inflation to near
zero (the target level). Sargent interprets the reduction in U.S. inflation
during the 1980s as just such an event: Sometime in the late 1970s, incoming
data began to suggest that the U.S. Phillips curve was vertical; policymakers
responded by lowering the inflation rate.
Sargent's analysis suggests that, unfortunately, the reduction in inflation
is not likely to be permanent. This is because policymakers' belief in
a vertical Phillips curve does not last. At some point, incoming data
again begin to suggest a tradeoff between unemployment and inflation,
and policymakers respond by trying to exploit the perceived tradeoff once
again. (Recall that the perceived tradeoff reflects the tradeoff between
unemployment and surprise inflation in the "true" model.) The whole cycle
then repeats itself. Simulations of his model show the economy cycling
between periods of high and low inflation, which mirrors changes in policymakers'
beliefs about the Phillips curve.
Declining inflation: a lucky break?
The two papers discussed so far attribute changes in inflation--and in
the correlation between economic activity and inflation--to changes in
policymakers' understanding of the economy. In sharp contrast, Ireland
suggests that the observed variation in inflation originated in events
that had little to do with monetary policy.
Ireland uses a well-known model of inflation due to Robert Barro and
David Gordon. In the Barro-Gordon model, surprise inflation leads to a
reduction in the unemployment rate. Policymakers have an incentive to
exploit this tradeoff, that is, to create surprise inflation in order
to push the unemployment rate below the level where market forces would
take it--this level is referred to as the natural rate of unemployment.
However, the public recognizes the temptation faced by the government
and adjusts its expectations of inflation accordingly. In equilibrium,
then, the economy ends up with higher than optimal inflation and unemployment
at the natural rate.
An important assumption of this model is that the gap between the natural
rate and the unemployment rate desired by policymakers varies positively
with the natural rate. This means, for instance, that the higher the natural
rate, the greater the amount by which policymakers want to reduce unemployment.
Since a greater reduction in unemployment can be obtained only by greater
(surprise) inflation, the end result is that inflation varies positively
with the natural rate.
Using data for the 1960-1990 period, Ireland shows that the long-run
relationship between U.S. inflation and unemployment is consistent with
the predictions of the Barro-Gordon model. While the short-run relationship
found in the data is not consistent with the model, Ireland believes that
this is not fatal for the theory, since the model being used is very simple.
Thus, the model can be used to explain the behavior of inflation as follows:
A series of negative shocks pushed the natural rate up during the 1970s.
Policymakers responded by pushing the inflation rate up, as implied by
the model. Positive shocks during the 1980s and 1990s then pushed the
natural rate down; policymakers responded by lowering the inflation rate.
Thus, Ireland argues that the rise in inflation during the 1970s reflected
bad luck rather than unusually bad policy, while the reduction in inflation
over the last two decades reflects good luck rather than good policy.
A better way to predict inflation
Gali and Gertler focus on the role firms play in determining the behavior
of the inflation rate. Their model is a variant of recent "New Keynesian"
models of the macroeconomy. In these models, firms are assumed to have
some monopoly power in the market, which allows them a degree of freedom
in setting prices for their products. These firms determine the price
they will charge by looking not only at current costs of production, but
also at anticipated costs, since prices cannot be adjusted instantaneously.
Because changes in costs are related to changes in output over the business
cycle, these models imply that prices should change before output does.
However, U.S. data show that changes in prices typically lag changes in
output over the business cycle.
Gali and Gertler make several changes to the basic New Keynesian model
to improve its ability to predict inflation. First, they assume that some
firms are backward-looking and use simple rules of thumb to set prices.
In addition, they employ a measure of the firms' marginal cost in order
to predict inflation, on the grounds that this is what matters for inflation
in the New Keynesian models, rather than more common measures of the output
gap used in earlier empirical work.
Gali and Gertler show that their model does quite well in explaining
the behavior of U.S. inflation over the 1960-1996 period. Further, their
estimates suggest that relatively few U.S. firms are backward-looking.
This result is important because the existence of backward-looking firms
often has been proposed as the reason for the empirical finding that prices
tend to be "sticky," that is, for the empirical finding that the price
level tends to change more slowly than is easily explained a priori. Their
finding implies that the observed stickiness in prices results from the
fact that real marginal costs are sticky. Stated more generally, sticky
prices reflect the fact that the variables that firms look at in order
to set prices themselves change slowly in response to changes in economic
conditions.
Summing up
Though the underlying issues are far from settled, the papers presented
at this workshop provide some interesting insights about the relationship
between economic activity and inflation. Haldane and Quah argue that the
conventional, downward-sloping Phillips curve does not represent a fundamental
relationship, and that the relationship we observe will change as policymakers'
beliefs about the economy change. Sargent's message is consistent, though
his paper focuses on the role of learning. Policymakers learn about the
economy by reestimating the Phillips curve as new data come in and vary
the rate of inflation in response to these changing estimates. Ireland
offers a plausible, alternative explanation for the observed variations
in U.S. inflation: Inflation went up during the 1970s and came down in
the 1980s because of the nature of the shocks hitting the economy and
not because policymakers learned something about how the economy functions.
Finally, the Gali and Gertler paper suggests that attempts to use economic
activity to forecast inflation will do better if one accounts for the
relationship between firms' marginal costs and inflation.
Bharat Trehan
Research Officer
References
Barro, Robert J., and David B. Gordon. 1983. "A Positive Theory of Monetary
Policy in a Natural Rate Model." Journal of Political Economy
91 pp. 589-610.
Gali, Jordi, and Mark Gertler. 1998. "Inflation Dynamics: A Structural
Econometric Analysis." Mimeo. New York University.
Haldane, Andrew, and Danny Quah. 1998. "U.K. Phillips Curves and
Monetary Policy." Mimeo. Bank of England.
Ireland, Peter. 1998. "Does the Time Consistency Problem Explain
the Behavior of U.S. Inflation?" Mimeo. Boston College.
Phillips, A.W. 1958. "The Relation Between Unemployment and the Rate
of Change of Money Wage Rates in the United Kingdom, 1861-1957." Economica
25 pp. 283-299.
Sargent, Thomas. 1999. "The Temporary (?) Conquest of American Inflation."
Mimeo. Stanford University.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
to:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
|
