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THEEVOLUTION ANDPOLICYIMPLICATIONS OF PHILLIPSCURVEANALYSIS Thomas At the core of modern version or another macroeconomics of the famous tionship between Phillips curve, both in its original reformulated In theoretical the so-called is some curve rela- and unemployment. versions, models “missing The has of inflation, equation” that steps that led to this change. graphs analysis, and disinflationary policies. expectations-augmented form, power of expansionary emphasizing real EARLY VERSIONS macro policy questions some reference be described depending upon the speed expectations. In fact, few are discussed to an analytical in terms of some version Finally, Brown As might be expected Phillips curve analysis beginnings pressure in 1958. has hardly Rather of events theorizing, from such a widely used tool, and incorporating stood still since its it has evolved the at progress each under the of economic stage such new elements as the natural rate hypothesis, the adaptiveexpectations mechanism, and most recently, the rational expectations hypothesis. Klein curve early efforts, have begun. That A. W. on percentage a stable horizontal enduring trade-off for the policymakers to exploit, it is now widely viewed as offering no trade-off at all. pretation: In short, excess demand the original of activist Phillips fine tuning curve notion has given of the way to the revised Phillips curve notion of policy ineffectiveness. The purpose of this article is to trace the sequence of article in which smooth, downward-sloping result, Kingshown measured horizontally, convex axis at a positive (w) in the United The was wages. excess The FEDERAL RESERVE BANK OF RICHMOND the response for labor as proxied the unemployment high rate. demand greater and a curve that cut the level of unemployment. The curve itself was given a straightforward it showed he data wages 1 with wage inflation unemployment of Pro- to annual of money rate (U) 1958 can be said to w=f(U) 1861-1913. in a chart like Figure the Phillips Despite it was not until famous and the unemployment dom for the period and chart by A. J. year saw the publication equation again in 1955. in 1957. analysis rates of change vertically curve was once seen as offering Sultan curve Phillips’ fitted a statistical than in the form of a dia- however, Phillips fessor Goldberger on a scatterplot by Paul that modern rather in 1936 and and Arthur it was graphed new element expanded its explanatory power. Each radically altered its policy implications. As a result, whereas potency Each is in the form of an econo- by Jan Tinbergen in 1955 and presented grammatic these curve. trade-off to unemployment It was stated by Lawrence at least of the Phillips OF THE PHILLIPS CURVE from inflation metric equation that might without framework at each of each innovation. ton (1802). It was identified statistically by Irving Fisher in 1926, although he viewed causation as vice versa. policy will either work slowly (and painfully) of price theoretical analysis The idea of an inflation-unemployment tionary of adjustment the that hardly new. It was a key component of the monetary doctrines of David Hume (1752) and Henry Thorn- running (and painlessly) into curve I. activity depends critically upon how price anticipations are formed. Similarly, it predicts that disinflaor swiftly in particular incorporated the para- of Phillips it contributing to of expansionary to stimulate Accordingly, the evolution ex- For example, in its it predicts that the measures sketch stage and the policy implications plains how changes in nominal income divide themselves into price and quantity components. On the policy front, it specifies conditions the effectiveness (or lack thereof) below innovations and more recently expectations-augmented two main uses. provides inflation Phillips M. Humphrey of wages by the inverse Low unemployment thus upward this excess interto the labor of spelled pressure on demand the 3 exist even when the market was in equilibrium, that is, when excess labor demand was zero and wages were stable. Accordingly, this frictional unemployFigure 1 ment was indicated EARLY PHILLIPS w Wage Inflation CURVE by the point at which the Phillips curve crosses the horizontal axis. According to Phillips, this is also the point to which the economy returns if the authorities ceased to maintain disequilibrium in the labor market by pegging the excess Rate (%) demand demand returns Phillips Curve Trade-off Relationship Between Inflation and Unemployment for labor. Finally, since increases in excess would likely run into diminishing marginal in reducing unemployment, it followed that the curve must be convex-this convexity showing that successive uniform decrements in unemployment would require progressively larger increments in excess demand achieve them. (and thus wage inflation rates) to Popularity of the Phillips Paradigm Once equipped Unemployment At unemployment is in equilibrium lower unemployment rates exists to bid up wages. At excess demand At higher unemploy- ment rates excess supply exists to bid down wages. The curve’s convex shape shows that increasing excess demand for labor runs into diminishing marginal employment. returns in reducing un- Thus successive uniform creases in unemployment arrows) require progressively in excess demand rates (vertical (horizontal de gray larger increases and hence wage inflation black arrows) as we go from point a to b to c to d along the curve. faster the rise in wages. Similarly, high unemployment spelled negative excess demand (i.e., excess labor supply) that put deflationary pressure on wages. Since the rate of change of wages varied directly with excess demand, which in turn varied inversely with unemployment, wage inflation would rise with decreasing unemployment and fall with increasing unemployment as indicated by the negative slope of the curve. Moreover, owing to unavoidable frictions in the operation of the labor market, it followed that some frictional unemployment would 4 ECONOMIC theoretical foun- important to understand why this was so. At least three factors probably contributed to the attractiveness of the Phillips curve. One was the remarkable temporal stability of the relationship, a stability revealed by Phillips’ own finding that the same curve rate Uf the labor market and wages are stable. with the foregoing dations, the Phillips curve gained swift acceptance among economists and policymakers alike. It is estimated for the pre-World War I period 1861-1913 fitted the United Kingdom data for the post-World War II period 1948-1957 equally well or even better. Such apparent stability in a two-variable relationship over such a long period of time is uncommon in empirical economics and served to excite interest in the curve. A second factor contributing to the success of the Phillips curve was its ability to accommodate a wide The Phillips curve variety of inflation theories. itself explained inflation as resulting from excess demand that bids up wages and prices. It was entirely neutral, however, about the causes of that phenomenon. Now excess demand can of course be generated either by shifts in demand or shifts in supply regardless of the causes of those shifts. Thus a demand-pull theorist could argue that excessdemand-induced inflation stems from excessively expansionary aggregate demand policies while a costpush theorist could claim that it emanates from tradeunion monopoly power and real shocks operating on labor supply. The Phillips curve could accommodate both views. Economists of rival schools could accept the Phillips curve as offering insights into the nature of the inflationary process even while disagreeing on the causes of and appropriate remedies for inflation. REVIEW, MARCH/APRIL 1985 Finally, the Phillips curve appealed to policymakers because it provided a convincing rationale for their apparent failure to achieve full employment with price stability-twin goals that were thought to be mutually compatible before Phillips’ analysis. When criticized for failing to achieve both goals simultaneously, the authorities could point to the Phillips curve as showing that such an outcome was impossible and that the best one could hope for was either arbitrarily low unemployment or price stability but not both. Note also that the curve, by offering a menu of alternative inflation-unemployment combinations from which the authorities could choose, provided a ready-made justification for discretionary intervention and activist fine tuning. Policymakers had but to select the best (or least undesirable) combination on the menu and then use their policy instruments to achieve it. For this reason too the curve must have appealed to some policy authorities, not to mention the economic advisors who supplied the cost-benefit analysis underlying their choices. From Wage-Change Relation to Price-Change Relation As noted above, the initial Phillips curve depicted a relation between unemployment and wage inflation. Policymakers, however, usually specify inflation targets in terms of rates of change of prices rather than wages. Accordingly, to make the Phillips curve more useful to policymakers, it was therefore necessary to transform it from a wage-change relationship to a price-change relationship. This transformation was achieved by assuming that prices are set by applying a constant mark-up to unit labor cost and so move in step with wages-or, more precisely, move at a rate equal to the differential between the percentage rates of growth of wages and productivity (the latter assumed zero here).l The result of this transformation was the price-change Phillips relation 1 Let prices P be the product of a fixed markup K (including normal profit margin and provision for depreciation) applied to unit labor costs C, (1) P = KC. Unit labor costs by definition wages W to labor productivity Q (2) C = W/Q. are the ratio of hourly or output per labor hour Substituting (2) into (l), taking logarithms of both of the resulting expression, and then differentiating respect to time yields sides with (3) P = w - q where the lower case letters denote the percentage rates of change of the price, wage, and productivity variables. Assuming productivity growth q is zero and the rate of wage change w is an inverse function of the unemployment rate yields equation (1) of the text. (1) P = ax(U) where p is the rate of price inflation, x(U) is overall excess demand in labor and hence product marketsthis excess demand being an inverse function of the unemployment rate-and a is a price-reaction coefficient expressing the response of inflation to excess demand. From this equation the authorities could determine how much unemployment would be associated with any given target rate of inflation. They could also use it to measure the effect of policies undertaken to obtain a more favorable Phillips curve, i.e., policies aimed at lowering the price-response coefficient and the amount of unemployment associated with any given level of excess demand. Trade-Offs and Attainable Combinations The foregoing equation specifies the position (or distance, from origin) and slope of the Phillips curve -two features stressed in policy discussions of the early 1960s. As seen by the policymakers of that era, the curve’s position fixes the inner boundary, or frontier, of feasible (attainable) combinations of inflation and unemployment rates (see Figure 2). Determined by the structure of labor and product markets, the position of the curve defines the set of all coordinates of inflation and unemployment rates the authorities could achieve via implementation of monetary and fiscal policies. Using these macroeconomic demand-management policies the authorities could put the economy anywhere on the curve. They could not, however, operate to the left of it. The Phillips curve was viewed as a constraint preventing them from achieving still lower levels of both inflation and unemployment. Given the structure of labor and product markets, it would be impossible for monetary and fiscal policy alone to reach inflationunemployment combinations in the region to the left of the curve. The slope of the curve was interpreted as showing the relevant policy trade-offs (rates of exchange between policy goals) available to the authorities. As explained in early Phillips curve analysis, these trade-offs arise because of the existence of irreconcilable conflicts among policy objectives. When the goals of full employment and price stability are not simultaneously achievable, then attempts to move the economy closer to one will necessarily move it further away from the other. The rate at which one objective must be given up to obtain a little bit more of the other is measured by the slope of the Phillips curve. For example, when the Phillips curve is steeply sloped, it means that a small reduction in unemploy- FEDERAL RESERVE BANK OF RICHMOND 5 rates of unemployment in exchange for permanently higher rates of inflation or vice versa. Put differently, the curve was interpreted as offering a menu of alternative inflation-unemployment combinations from which the authorities could choose. Given the menu, the authorities’ task was to select the particular inflation-unemployment mix resulting in the smallest social cost (see Figure 3). To do this, they would have to assign relative weights to the twin evils of Figure 2 TRADE-OFFS ATTAINABLE p Price Inflation The Rate (%) position curve or defines attainable nations. location the Using monetary upon the Phillips or set the frontier acts as a all combinations itself but it. constraint on of the shows the trade-offs exchange inflation choices. between the in demand- policy of none In this way the management curve of combi- and fiscal policies, can attain the shaded region below curve of frontier inflation-unemployment the authorities lying AND COMBINATIONS The two slope or rates evils of and unemployment. The ment would be purchased at the cost of a large increase in the rate of inflation. Conversely, in relatively flat portions of the curve, considerably lower unemployment could be obtained fairly cheaply, that is at the. cost of only slight increases in inflation. Knowledge of these trade-offs, would enable the authorities to, determine the price-stability sacrifice necessary to buy any given reduction in the unemployment rate. of resulting harm. REVIEW, MARCH/APRIL inflation in a given shows all the comand reflect inflation weights authority) and combination inflation curve appearing on the disutility contour. The and ment that the policymakers lowest from unemployment will (or the unit just is the attainable Here a best unemploy- can reach, given constraint, benefit 1985 that society assigns to the evils of unemployment. of Phillips the lower The slopes of these contours the relative the policy the unemployment level of social cost or The closer to the origin, the social cost. extra inflation ECONOMIC are social disutility binations The preceding has described the early view of the Phillips curve as a stable, enduring. trade-off permitting the authorities to obtain permanently lower 6 curves Each contour social The Best Selection on the Phillips Frontier bowed-out contours. mix social additional reduction be cost of doing so. worth in the inflation and unemployment in accordance with their views of the comparative harm caused by each. Then, using monetary and fiscal policy, they would move along the Phillips curve, trading off unemployment for inflation (or vice versa) until they reached the point at which the additional benefit from a further reduction in unemployment was just worth the extra inflation cost of doing so. Here would be the optimum, or least undesirable, mix of inflation and unemployment. At this point the economy would be on its lowest attainable social disutility contour (the bowedout curves radiating outward from the origin of Figure 3) allowed by the Phillips curve constraint. Here the unemployment-inflation combination chosen would be the one that minimized social harm. It was of course understood that if this outcome involved a positive rate of inflation, continuous excess money growth would be required to maintain it. For without such monetary stimulus, excess demand would disappear and the economy would return to the point at which the Phillips curve crosses the horizontal axis. Different Preferences, Different Outcomes It was also recognized that policymakers might differ in their assessment of the comparative social cost of inflation vs. unemployment and thus assign different policy weights to each. Policymakers who believed that unemployment was more undesirable than rising prices would assign a much higher relative weight to the former than would policymakers who judged inflation to be the worse evil. Hence, those with a marked aversion to unemployment would prefer a point higher up on the Phillips curve than would those more anxious to avoid inflation, as shown in Figure 4. Whereas one political administration might opt for a high pressure economy on the grounds that the social benefits of low unemployment exceeded the harm done by the inflation necessary to achieve it, another administration might deliberately aim for a low pressure economy because it believed that some economic slack was a relatively painless means of eradicating harmful inflation. Both groups would of course prefer combinations to the southwest of the Phillips constraint, down closer to the figure’s origin (the ideal point of zero inflation and zero unemployment). As pointed out before, however, this would be impossible given the structure of the economy, which determines the position or location of the Phillips frontier. In short, the policymakers would be constrained to combinations lying on this boundary, unless they were prepared to alter the economy’s structure. Different differ political in their harmfulness of inflation unemployment. erations administrations evaluations of relative they will attach These employment. contours by the contours to that of different weights (as those contours policymakers). and un- will be re- are interpreted The relatively flat reflect the views of those attaching higher relative weight to the evils of inflato those assigning higher weight to unemployment. ployment-averse inflation delib relative in the slopes of the social disutility tion; the steep contours a point social Thus in their policy weights to the two evils of inflation flected may the administration An unemwill choose on the Phillips curve involving more and combination less unemployment selected than the by an inflation-averse administration. Pessimistic Phillips Curve and the “Cruel Dilemma” In the early 1960s there was much discussion of the so-called “cruel-dilemma” problem imposed by an unfavorable Phillips curve. The cruel dilemma refers FEDERAL RESERVE BANK OF RICHMOND 7 to certain pessimistic situations where none of the available combinations on the menu of policy choices is acceptable to the majority of a country’s voters (see Figure 5). For example, suppose there is some maximum rate of inflation, A, that voters are just willing to tolerate without removing the party in Likewise, suppose there is some maximum power. tolerable rate of unemployment, B. As shown in Figure 5, these limits define the zone of acceptable or politically feasible combinations of inflation and unemployment. A Phillips curve that occupies a position anywhere within this zone will satisfy society’s demands for reasonable price stability and high employment. But if both limits are exceeded and the curve lies outside the region of satisfactory outcomes, the system’s performance will fall short of what was expected of it, and the resulting discontent may severely aggravate political and social tensions. If, as some analysts alleged, the Phillips curve tended to be located so far to the right in the chart that no portion of it fell within the zone of acceptable combinations, then the policymakers would indeed be At best they confronted with a painful dilemma. could hold only one of the variables, inflation or unemployment, down to acceptable levels. But they could not hold both simultaneously within the limits of toleration. Faced with such a pessimistic Phillips curve, policymakers armed only with traditional demand-management policies would find it impossible to achieve combinations of inflation and unemployment acceptable to society. Figure 5 PESSIMISTIC PHILLIPS CURVE AND THE “CRUEL DILEMMA” p Price Inflation Pessimistic or Unfavorable Phillips Curve; Lies Outside the Zone of Tolerable Outcomes Phillips Curve Shifted Down by Incomes and/or A = Maximum Tolerable Rate of Inflation B = Maximum Tolerable Rate of Unemployment Given the unfavorable makers are confronted They tion can achieve (point (wage-price) Phillips curve, policywith a cruel choice. acceptable The rationale and structural into the zone of tolerable Of these measures, incomes policies would be directed at the price-response coefficient linking inflaEither by decreeing this tion to excess demand. ECONOMIC (point b) for incomes (labor market) policies was to shift the Phillips curve down It was this concern and frustration over the seeming inability of monetary and fiscal policy to resolve the unemployment-inflation dilemma that induced some economists in the early 1960s to urge the adoption of incomes (wage-price) and structural (labormarket) policies. Monetary and fiscal policies alone were thought to be insufficient to resolve the cruel dilemma since the most these policies could do was to enable the economy to occupy alternative positions on That is, monetary the pessimistic Phillips curve. and fiscal policies could move the economy along the given curve, but they could not move the curve itself into the zone of tolerable outcomes. What was needed, it was argued, were new policies that would twist or shift the Phillips frontier toward the origin of the diagram. 8 rates of infla- a) or unemployment but not both. Policies to Shift the Phillips Curve Rate outcomes. coefficient to be zero (as with wage-price freezes), or by replacing it with an officially mandated rate of price increase, or simply by persuading sellers to moderate their wage and price demands, such policies would lower the rate of inflation associated with any given level of unemployment and thus twist down the Phillips curve. The idea was that wage-price controls would hold inflation down while excess demand was being used to boost employment. Should incomes policies prove unworkable or prohibitively expensive in terms of their resourcemisallocation and restriction-of-freedom costs, then the authorities could rely solely on microeconomic structural policies to improve the trade-off. By en- REVIEW, MARCH/APRIL 1985 hancing the efficiency and performance of labor and product markets, these latter policies could lower the Phillips curve by reducing the amount of unemployment associated with any given level of excess demand. Thus the rationale for such measures as jobtraining and retraining programs, job-information and job-counseling services, relocation subsidies, antidiscrimination laws and the like was to shift the Phillips frontier down so that the economy could obtain better inflation-unemployment combinations. II. INTRODUCTION OF SHIFT VARIABLES Up until the mid-1960s the Phillips curve received widespread and largely uncritical acceptance. Few questioned the usefulness, let alone the existence, of this construct. In policy discussions as well as economic textbooks, the Phillips curve was treated as a stable, enduring relationship or menu of policy choices. Being stable (and barring the application of incomes and structural policies), the menu never changed. Empirical studies of the 1900-1958 U. S. data soon revealed, however, that the menu for this country was hardly as stable as its original British counterpart and that the Phillips curve had a tendency to shift over time. Accordingly, the trade-off equation was augmented with additional variables to account for such movements. The inclusion of these shift variables marked the second stage of Phillips curve analysis and meant that the trade-off equation could be written as (2) P = ax(U)+z where z is a vector of variables-productivity, profits, trade union effects, unemployment dispersion and the like-thought capable of shifting the inflationunemployment trade-off. In retrospect, this vector or list was deficient both for what it included and what it left out. Excluded at this stage were variables representing inflation expectations-later shown to be a chief cause of the shifting short-run Phillips curve. Of the variables included, subsequent analysis would reveal that at least three-productivity, profits, and measures of union monopoly power-were redundant because they constituted underlying determinants of the demand for and supply of labor and as such were already captured by the excess demand variable, U. This criticism, however, did not apply to the unemployment dispersion variable, changes in which were independent of excess demand and were indeed capable of causing shifts in the aggregate Phillips curve. To explain how the dispersion of unemployment across separate micro labor markets could affect the aggregate trade-off, analysts in the early 1960s used diagrams similar to Figure 6. That figure depicts a representative micromarket Phillips curve, the exact replica of which is presumed to exist in each local labor market and aggregation over which yields the macro Phillips curve. According to the figure, if a given national unemployment rate U* were equally distributed across local labor markets such that the same rate prevailed in each, then wages everywhere would inflate at the single rate indicated by the point w* on the curve, But if the same aggregate unemployment were unequally distributed across local markets, then wages in the different markets would Because of the curve’s inflate at different rates. convexity (which renders wage inflation more responsive to leftward than to rightward deviations from average unemployment along the curve) the average of these wage inflation rates would exceed In short, the the rate of the no-dispersion case. diagram suggested that, for any given aggregate unemployment rate, the rate of aggregate wage inflation varies directly with the dispersion of unemployment across micromarkets, thus displacing the macro Phillips curve to the right. From this analysis, economists in the early 1960s concluded that the greater the dispersion, the greater the outward shift of the aggregate Phillips curve. To prevent such shifts, the authorities were advised to apply structural policies to minimize the dispersion of unemployment across industries, regions, and occupations. Also, they were advised to minimize unemployment’s dispersion over time since, with a convex Phillips curve, the average inflation rate would be higher the more unemployment is allowed to fluctuate around its average (mean) rate. A Serious Misspecification The preceding has shown how shift variables were first incorporated into the Phillips curve in the earlyNotably absent at this stage were to mid-1960s. To be variables representing price expectations. sure, the past rate of price change was sometimes used as a shift variable to represent catch-up or costof-living adjustment factors in wage and price deRarely, however, was it interpreted as a mands. proxy for anticipated inflation. Not until the late 1960s were expectational variables fully incorporated By then, of course, into Phillips curve equations. FEDERAL RESERVE BANK OF RICHMOND 9 inflationary expectations had become to ignore and many analysts the dominant too prominent were perceiving cause of observed them as shifts in the Phillips curve. Coinciding Figure 6 recognition EFFECTS OF UNEMPLOYMENT DISPERSION with misspecification trade-off. Rate perception was Phillips that could incorporation w Wage Inflation this that the original only be corrected of a price expectations The original Phillips than economic nominal however, wages it follows variable by the in the Since w=f(U). that real rather theory teaches adjust to clear that a curve was expressed in terms of nominal wage changes, neoclassical the belated curve involved labor the Phillips curve markets, should have been stated Better still (since in terms of real wage changes. wage bargains are made with an eye to the future), it should have been stated in terms of expected real wage between the rates expected future original term Phillips to render prices, curve curve described i.e., the differential of nominal w-pe=f(U). required it correct. led to the development Phillips changes, of change wages In short, and the a price expectations Recognition of this fact of the expectations-augmented below. Ill. THE EXPECTATIONS-AUGMENTED AND If aggregate unemployment at rate U* were evenly individual labor distributed markets everywhere, rate w* across such that aggregate then wages would inflate at the unemployment U* distributed such market A that and UB But if is unequally rate UA in market exists and WB in the latter. local inflation ment rate inflation U* inflation is wo rate the is higher than the with unemployment. dispersion case. the dispersion higher associated level of aggregate ployment which of the no-dispersion The greater unemployment, market The average of these rates at aggregate unemploy- rate w* Conclusion: in B, then wages will inflate at rate WA in the former shifts the of aggregate any given Unem- aggregate Phillips curve rightward. 10 ECONOMIC PHILLIPS CURVE MECHANISM The original Phillips curve equation gave way to the expectations-augmented version in the early 1970s. Three innovations ushered in this change. The first was the respecification of the excess demand variable. Originally defined as an inverse function of the unemployment rate, x(U), excess demand was redefined as the discrepancy or gap between the natural and actual rates of unemployment, UN-U. The natural (or full employment) rate of unemployment itself was defined as the rate that prevails in steady-state equilibrium when expectations are fully realized and incorporated into all wages and prices and inflation is neither accelerating nor decelerating. It is natural in the sense (1) that it represents normal full-employment equilibrium in the labor and hence commodity markets, (2) that it is independent of the steady-state inflation rate, and (3) that it is determined by real structural forces (market frictions and imperfections, job information and labor mobility costs, tax laws, unemployment subsidies, and the like) and as such is not susceptible to manipulation by aggregate demand policies. the same rate prevailed both locally and nationally. THE ADAPTIVE-EXPECTATIONS REVIEW, MARCH/APRIL 1985 The second innovation was the introduction price anticipations into Phillips curve analysis sulting in the expectations-augmented equation of re- an amount equal to half the error, points. Such revision will continue tational error is eliminated. Analysts also demonstrated that equation 4 is equivalent to the proposition that expected inflation is a geometrically declining weighted average of all past rates of inflation with the weights summing to one. This unit sum of weights ensures that any constant rate of inflation eventually will be fully anticipated, as can be seen by writing the error-learning mechanism as (3) p = a(UN-U)+pe where excess demand is now written as the gap between the natural and actual unemployment rates and pe is the price expectations variable representing the anticipated rate of inflation. This expectations variable entered the equation with a coefficient of unity, reflecting the assumption that price expectations are completely incorporated in actual price changes. The unit expectations coefficient implies the absence of money illusion, i.e., it implies that people are concerned with the expected real purchasing power of the prices they pay and receive (or, alternatively, that they wish to maintain their prices relative to the prices they expect others to be charging) and so take anticipated inflation into account. As will be shown later, the unit expectations coefficient also implies the complete absence of a trade-off between inflation and unemployment in long-run equilibrium when expectations are fully realized. Note also that the expectations variable is the sole shift variable in the equation. All other shift variables have been omitted, reflecting the view, prevalent in the early 1970s that changing price expectations were the predominant cause of observed shifts in the Phillips curve. Expectations-Generating where indicates the operation of summing the past rates of inflation, the subscript i denotes past time periods, and vi denotes the weights attached to past With a stable inflation rate p rates of inflation. unchanging over time and a unit sum of weights, the equation’s right-hand side becomes simply p, indicating that when expectations are formulated adaptively via the error-learning scheme, any constant rate of inflation will indeed eventually be fully anticipated. Both versions of the adaptive-expectations mechanism (i.e., equations 4 and 5) were combined with the expectations-augmented Phillips equation to explain the mutual interaction of actual inflation, expected inflation, and excess demand. The Natural Rate Hypothesis Mechanism These three innovations-the redefined excess demand variable, the expectations-augmented Phillips curve, and the error-learning mechanism-formed the basis of the celebrated natural rate and accelerationist hypotheses that radically altered economists’ and policymakers’ views of the Phillips curve in the late According to the natural 1960s and early 1970s. rate hypothesis, there exists no permanent trade-off between unemployment and inflation since real economic variables tend to be independent of nominal ones in steady-state equilibrium. To be sure, tradeoffs may exist in the short run. For example, surprise inflation, if unperceived by wage earners, may, by raising product prices relative to nominal wages and thus lowering real wages, stimulate employment But such trade-offs are inherently temporarily. transitory phenomena that stem from unexpected inflation and that vanish once expectations (and the wages and prices embodying them) fully adjust to inflationary experience. In the long run, when inflationary surprises disappear and expectations are realized such that wages reestablish their preexisting levels relative to product prices, unemployment The third innovation was the incorporation of an expectations-generating mechanism into Phillips curve analysis to explain how the price expectations variable itself was determined. Generally a simple adaptive-expectations or error-learning mechanism According to this mechanism, expectawas used. tions are adjusted (adapted) by some fraction of the forecast error that occurs when inflation turns out to be different than expected. In symbols, where the dot over the price expectations variable indicates the rate of change (time derivative) of that variable, p-pe is the expectations or forecast error (i.e., the difference between actual and expected price inflation), and b is the adjustment fraction. Assuming, for example, an adjustment fraction of ½, equation 4 says that if the actual and expected rates of inflation are 10 percent and 4 percent, respectivelyi.e., the expectational error is 6 percent-then the expected rate of inflation will be revised upward by FEDERAL RESERVE or 3 percentage until the expec- BANK OF RICHMOND 11 returns to its natural is compatible with rates of inflation, curve (equilibrium) all fully implying is a vertical rate. anticipated This rate steady-state that the long-run line at the natural Phillips rate of unem- ployment. Equation tion, 3 embodies when these conclusions. rearranged to read states that the trade-off tion (the difference inflation, p-pe) surprise price is between between unexpected actual and and unemployment. increases unemployment could is fully anticipated guaranteed is, only deviations of rate. The equation disappears when inflation (i.e., when p-p” for any steady the error-learning infla- expected That induce from its natural also says that the trade-off result That equa- p-pe=a(UN-U), mechanism’s equals zero), rate of inflation a by unit sum of weights. Moreover, according to the equation, the right-hand side must also be zero at this point, which implies that unemployment is at its natural rate. The natural rate of unemployment is therefore compatible with any constant rate anticipated (which the error-learning equation of inflation it eventually to one). In short, 3 asserts that inflation-unemployment trade- offs cannot weights provided it is fully must be by virtue of exist when adding inflation is fully anticipated. And equation 5 ensures that this latter condition must obtain for all steady inflation rates such that the long-run Phillips curve is a vertical line at the natural The vertical rate of unemployment.2 of unemployment The message of the natural A higher clear. buy a permanent stable curve are inherently to exploit the permanent ing a lasting of inflation Phillips 7). could not Movements to that reduction shift the unemployment to its In sum, Phillips curve transitory phenomena. them will only succeed rate of inflation was curve only provoke adjustments and restore rate (see Figure trade-offs tempts wage/price to the right natural hypothesis drop in joblessness. the left along a short-run expectational rate rate without At- in raising accomplish- in the unemployment rate. 12 ECONOMIC the natural rate UN is the long-run steady state Phillips curve along which all rates of inflation are fully ward-sloping curves lower are The down- short-run corresponding given expected to anticipated. lines each to rate of inflation. unemployment from Phillips a different Attempts the natural rate UN to U1 by raising inflation to 3 per- cent along the short-run curve S0 trade-off will only induce shifts in the short-run to S1 S2, higher rate S3 as expectations of travels the path state equilibrium, ment inflation. ABCDE curve adjust to the The economy to the new steady point E, where unemploy- is at its preexisting inflation 2 Actually, the long-run Phillips curve may become positively sloped in its upper ranges as higher inflation leads to greater inflation variability (volatility, unpredictability) that raises the natural rate of unemployment. Higher and hence more variable and erratic inflation can raise the equilibrium level of unemployment by generating increased uncertainty that inhibits business activity and by introducing noise into market price signals, thus reducing the efficiency of the price system as a coordinating and allocating mechanism. line L through natural rate but is higher than it was originally. The Accelerationist Hypothesis The expectations-augmented Phillips curve, when also combined with the error-learning process, yielded the celebrated accelerationist hypothesis that REVIEW, MARCH/APRIL 1985 dominated many policy discussions 1970s. This hypothesis, in the inflationary a corollary of the natural rate concept, states that since there exists no long-run trade-off tempts between unemployment to peg the former (equilibrium) level variable must Fueled expansion, such price acceleration always thereby perpetuating prevent unemployment rium level (see Figure at- faster Figure 8 THE ACCELERATIONIST HYPOTHESIS ever-increasing by progressively running inflation, below its natural produce inflation. inflation and monetary would keep actual ahead of expected the inflationary from returning inflation, surprises that to its equilib- 8). Accelerationists reached these conclusions via the They noted that equation 3 posits following route. that unemployment can differ from its natural level only so long as actual inflation deviates from exBut that same equation together pected inflation. with equation 4 implies that, by the very nature of the error-learning mechanism, such deviations cannot persist unless inflation is continually accelerated so that it always stays ahead of expected inflation3 If inflation is not accelerated, but instead stays constant, then the gap between actual and expected inflation will eventually be closed. Therefore acceleration is required to keep the gap open if unemployment is to be maintained below its natural equilibrium level. In other words, the long-run trade-off implied by the accelerationist hypothesis is between unemployment and the rate of acceleration of the inflation rate, in contrast to the conventional trade-off between unemployment and the inflation rate itself as implied by the original Phillips curve.4 Since the adjustment inflation its natural equilibrium frustrates its accelerate says that the acceleration of inflation to its natural rate. trade-off is between the and unemployment expecta- attempts will to provoke inflation. the path ABCD to peg exploThe with rising from zero to p1 etc. to stay 4 The proof is simple. Merely substitute equation 3 into the expression presented in the preceding footnote to obtain which travel of unemployment Thus at U1 the rate of inflation to p2 to p3 a continuous adjustment ever-accelerating will at Such surprises, perpetually return rate. unemployment economy rate must generating full would natural inflation low level such as U1. by the that the must wish to peg unemployment sive, says that the inflation of expected inflation. the authorities (accelerate) to at any rate if they tions which ahead UN raise succession of inflation 3 Taking the time derivative of equation 3, then assuming that the deviation of U from UN is pegged at a constant level by the authorities such that its rate of change is zero, and then substituting equation 4 into the resulting expression yields level steady rate of inflation, acceleration, At least two policy implications stemmed from the First, natural rate and accelerationist propositions. to actual continually some arbitrarily Policy Implications of the Natural Rate and Accelerationist Hypotheses of expected works to restore unemployment rate of U relative the authorities could either peg unemployment or stabilize the rate of inflation but not both. If they pegged unemployment, they would lose control of the rate of inflation because the latter accelerates when unemployment is held below its natural level. Alternatively, if they stabilized the inflation rate, FEDERAL RESERVE BANK OF RICHMOND 13 they would latter lose control returns rate to its of inflation. Phillips however, natural Thus, hypothesis, at a given policy rate hypothesis from tion. target inflationary inflation only way capacity to its natural the authorities inflation from transitional NATURAL RATE HYPOTHESIS could wished to move from a a major But equations low lower determinant of the 3 and 4 state that the expectations supply the adjust- must is to create in the The preceding Phillips slack economy. was conducted in the early- to mid-1970s, of inflationary expectations the the way rational for of the latter.5 The equations amount adjustment comes down of slack created.6 Much and a relatively rapid also indicate depends on the slack means attainment fast of rate hyinvolved These tests, led to criticisms or error-learning model and thus helped prepare introduction expectations stage stage hypothesis. of the adaptive-expectations of the idea into Phillips alternative curve analysis. The tests themselves were mainly concerned with estimating the numerical value of the coefficient on the price-expectations augmented Phillips variable sis is valid If the coefficient 3, then the natural and no long-run is Analysts is less than refuted and emphasized expectations-augmented rate hypothe- inflation-unemployment exists for the policymakers hypothesis exists. in the expectations- curve equation. is one, as in equation if the coefficient revision of that fourth testing below the expected that how fast inflation The statistical trade-off a downward the third in which the natural formed. Such slack raises unemployment above its natural level and thereby causes the actual rate of inflation to fall rate so as to induce has examined curve analysis pothesis rate of infla- To do so, they to lower level. rate to a zero or other rate. or excess stemming steady-state expectations, rate. They could, inflation rate at alternative to the desired inflation STATISTICAL TESTS OF THE original was that the authorities among Suppose IV. steady of inflation. implication natural high inherited any to the steady-state returns choose paths at contrary rate the which unemployment ment level since the they could not peg unemployment constant choose A second of unemployment to exploit. But one, the natural rate a long-run trade-off this fact by writing equation the as of the inflation target. Conversely, little slack means sluggish adjustment and a relatively slow attainment of the inflation target. Thus the policy choice is between adjustment paths offering high excess unemployment where ø is the coefficient (with a value of between zero and one) attached to the price expectations variable. In long-run equilibrium, of course, expected for a short time or lower excess unemployment inflation equals expected inflation long time (see Figure for a 9).7 for long-run tion 3 into equation 4 to obtain = This expression says Simply substitute i.e., pe=p. and solving Setting as required for the actual yields equa- ba(UN-U). that expectations downward ( will be negative) exceeds its natural rate. only will be adjusted if unemployment 6 Note that the equation developed in footnote 4 states that disinflation will occur at a faster pace the larger the unemployment gap. 7 Controls advocates proposed a third policy choice: use wage-price controls to hold actual below expected inflation so as to force a swift reduction of the latter. Overlooked was the fact that controls would have little impact on expectations unless the public was convinced that the trend of prices when controls were in force was a reliable indicator of the future price trend after controls were lifted. Convincing the public would be difficult if controls had failed to stop inflation in the past. Aside from this, it is hard to see why controls should have a stronger impact on expectations than a preannounced, demonstrated policy of disinflationary money growth. 14 inflation, equal to actual inflation equilibrium rate of inflation 5 The proof is straightforward. actual ECONOMIC Besides showing that the long-run Phillips curve is steeper than its short-run counterpart (since the slope parameter of the former, a/(l-ø), exceeds that of the latter, a), equation 7 shows that a long-run tradeoff exists only if the expectations coefficient ø is less than one. If the coefficient is one, however, the slope term is infinite, which means that there is no relation between inflation and unemployment so that the trade-off vanishes (see Figure 10). Many of the empirical tests estimated the coefficient to be less than unity and concluded that the natural rate hypothesis was invalid. But this ‘conclusion was sharply challenged by economists who contended that the tests contained statistical bias that REVIEW, MARCH/APRIL 1985 Figure 9 ALTERNATIVE DISINFLATION PATHS ADEB ACB = Fast disinflation path involving high excess unemployment for a short time. To move from along short-run inducing point high-inflation the downward B is reached. the unemployment ployment point A to zero-inflation Phillips curve SA, lowering actual revision of expectations point B the authorities relative of expectations must first travel inflation and, thereby curve Ieftward until depends upon the size of that point B will be reached faster via the high excess unem- path ACB than via the low excess unemployment high excess unemployment to expected that shifts the short-run Since the speed of adjustment gap, it follows = Gradualist disinflation path involving low excess unemployment for a long time. path ADEB. for a short time or low excess unemployment tended to work against the natural rate hypothesis. These critics pointed out that the tests typically used adaptive-expectations schemes as empirical proxies for the unobservable price expectations variable. They further showed that if these proxies were inappropriate measures of inflationary expectations then estimates of the expectations coefficient could well be biased downward. If so, then estimated coefficients of less than one constituted no disproof of the natural rate hypothesis. Rather they constituted evidence of inadequate measures of expectations. Thechoice is between for a long time. Shortcomings of the Adaptive-Expectations Assumption In connection with the foregoing, the critics argued that the adaptive-expectations scheme is a grossly inaccurate representation of how people formulate price expectations. They pointed out that it postu- lates naive expectational behavior, holding as it does that people form anticipations solely from a weighted average of past price experience with weights are fixed and independent of economic conditions FEDERAL RESERVE BANK OF RICHMOND that and 15 tional errors. That people would fail to exploit information that would improve expectational accuracy seems implausible, however. In short, the critics contended that adaptive expectations are not wholly rational if other information besides past price changes can improve inflation predictions. Figure 10 THE EXPECTATIONS COEFFICIENT AND THE LONG-RUN STEADY-STATE PHILLIPS CURVE p Price inflation Many economists have since pointed out that it is hard to accept the notion that individuals would continually form price anticipations from any scheme that is inconsistent with the way inflation is actually generated in the economy. Being different from the true inflation-generating mechanism, such schemes will produce expectations that are systematically wrong. If so, rational forecasters will cease to use them. For example, suppose inflation were actually accelerating or decelerating. According to equation 5, the adaptive-expectations model would systematically underestimate the inflation rate in the former case and overestimate it in the latter. Using a unit weighted average of past inflation rates to forecast a steadily rising or falling rate would yield a succession of one-way errors. The discrepancy between actual and expected inflation would persist in a perfectly predictable way such that forecasters would be provided free the information needed to correct their mistakes. Perceiving these persistent expectational mistakes, rational individuals would quickly abandon the error-learning model for more accurate expectations-generating schemes. Once again, the adaptive-expectations mechanism is implausible because of its incompatibility with rational behavior. Rate I Long-run Phillips Curve: Statistical tests thesis sought of the of the expectations long run natural to determine steady-state rate the hypo- magnitude coefficient ø in the Phillips curve equation V. A coefficient nent of one means that trade-off exists and Phillips curve is a vertical natural the existence of less than of a long-run FROM ADAPTIVE steady-state line through rate of unemployment. a coefficient no perma- RATIONAL the are exploit. Note steeper cating that favorable than one signifies the Phillips curve trade that the the long run short-run permanent than temporary curves ones, trade-offs indi- are less ones. policy actions. It implies that people look only at past price changes and ignore all other pertinent information-e.g., change rate movements, and the like-that 16 money growth announced TO EXPECTATIONS Conversely, off with negative slope for the policymakers to EXPECTATIONS rate changes, ex- policy intentions could be used to reduce expecta- ECONOMIC The shortcomings of the adaptive-expectations approach to the modeling of expectations led to the incorporation of the alternative rational expectations approach into Phillips curve analysis. According to the rational expectations hypothesis, individuals will tend to exploit all available pertinent information about the inflationary process when making their price forecasts. If true, this means that forecasting errors ultimately could arise only from random (unforeseen) shocks occurring to the economy. At first, of course, price forecasting errors might also arise because individuals initially possess limited or incomplete information about, say, an unprecedented new policy regime, economic structure, or inflationgenerating mechanism. But it is unlikely that this condition would persist. For if the public were REVIEW, MARCH/APRIL 1985 truly rational, it would quickly learn from these inflationary surprises or prediction errors (data on which it acquires costlessly as a side condition of buying goods) and incorporate the free new information into its forecasting procedures, i.e., the source of forecasting mistakes would be swiftly perceived and systematically eradicated. As knowledge of policy and the inflationary process improved, forecasting models would be continually revised to produce more accurate predictions. Soon all systematic (predictable) elements influencing the rate of inflation would become known and fully understood, and individuals’ price expectations would constitute the most accurate (unbiased) forecast consistent with that knowledge.8 When this happened the economy would converge to its rational expectations equilibrium and people’s price expectations would be the same as those implied by the actual inflation-generating mechanism. As incorporated in natural rate Phillips curve models, the rational expectations hypothesis implies that thereafter, except for unavoidable surprises due to purely random shocks, price expectations would always be correct and the economy would always be at its long-run steady-state equilibrium. Policy Implications of Rational Expectations The strict (flexible price, instantaneous market clearing) rational expectations approach has radical policy implications. When incorporated into natural rate Phillips curve equations, it implies that systematic policies-i.e., those based on feedback control rules defining the authorities’ response to changes in the economy-cannot influence real variables such as output and unemployment even in the short run, since people would have already anticipated what the policies are going to be and acted upon those anticipations. To have an impact on output and employment, the authorities must be able to create a divergence between actual and expected inflation. This follows from the proposition that inflation influences real variables only when it is unanticipated. To lower unemployment in the Phillips curve equation p-pe= a(UN-U), the authorities must be able to alter the actual rate of inflation without simultaneously causing an identical change in the expected future rate. This may be impossible if the public can predict policy actions. 8Put differently, rationality implies that current expectational errors are uncorrelated with past errors and with all other known information, such correlations already having been perceived and exploited in the process of improving price forecasts. Policy actions, are predictable. to the extent Systematic they are systematic, policies are simply feed- back rules or response functions relating ables of other economic to past values These policy response functions incorporated into forecasters’ other words, rational vations the policy rule. use current moves. Then, can correct forehand to discover the rule, they can on the variables respond In can use past obser- of the authorities observations and price predictions. Once they know the policymakers variables. can be estimated individuals on the behavior policy vari- to predict to which future policy on the basis of these predictions, for the effect of anticipated by making appropriate they policies adjustments be- to nomi- nal wages and prices. Consequently, when stabilizado occur, they will have no impact on tion actions real variables like unemployment been discounted rules-based since they will have and neutralized in advance. In short, policies, being in the information set used by rational forecasters, will be perfectly anticipated and for that reason will have no impact on unemployment. The only conceivable way that policy can have even a short-run influence on real variables is for it to be unexpected, i.e., the policymakers must either act in an unpredictable random fashion or secretly change the policy which are rule. incompatible Apart with from most such tactics, notions of the proper conduct of public policy, there is no way the authorities can influence real variables, i.e., cause them to deviate from their natural equilibrium levels. The authorities can, however, influence a nominal variable, centrate rate namely the inflation their efforts (e.g., zero) approach on doing con- so if some particular is desired. As for disinflation tions rate, and should strategy, generally calls the rational expecta- for a preannounced sharp swift reduction in money growth-provided of course that the government’s commitment to ending inflation is sufficiently credible ing chosen a zero target convinced to be believed. Hav- rate of inflation and having the public of their determination to achieve it, the policy authorities without creating a costly should be able to do so transitional rise in unem- ployment. For, given that rational expectations adjust infinitely faster than adaptive expectations to a credible preannounced disinflationary policy (and also that wages and prices continuously) the transition be relatively FEDERAL RESERVE BANK OF RICHMOND adjust to clear markets to price stability should quick and painless (see Figure 11). 17 natural rate Phillips curve models. Under adaptiveexpectations, short-run trade-offs exist because such expectations, being backward looking and slow to respond, do not adjust instantaneously to eliminate forecast errors arising from policy-engineered changes in the inflation rate. With expectations adapting to actual inflation with a lag, monetary policy can generate unexpected inflation and consequently influence real variables in the short run. This cannot happen under rational expectations where both actual and expected inflation adjust identically and instantaneously to anticipated policy changes. In short, under rational expectations, systematic policy cannot induce the expectational errors that generate short-run Phillips curves.9 Phillips curves may exist, to be sure. But they are purely adventitious phenomena that are entirely the result of unpredictable random shocks and cannot be exploited by policies based upon rules. Figure 11 COSTLESS DISINFLATION UNDER RATIONAL EXPECTATIONS POLICY Assuming AND CREDIBILITY expectational rationality, wage/ price flexibility, and full policy credibility, preannounced permanent money Stable growth prices to and thus actual accompanying reduction inflation transitory ment. The economy lowers to zero with expected with moves immediately from steady-state Phillips curve. Here is the basic prediction model: rational affect expectations-natural that fully anticipated (including only credible inflation VI. of rate EVALUATION policy changes preannounced but no rise in unemploy- point A to point B on thevertical the a in a level consistent theoretically In sum, no role remains for systematic countercyclical stabilization policy in Phillips curve models embodying rational expectations and the natural rate hypothesis. The only thing such policy can influence in these models is the rate of inflation which adjusts immediately to expected changes in money growth. Since the models teach that the full effect of rules-based policies is on the inflation rate, it follows that the authorities-provided they believe that the models are at all an accurate representation of the way the world works-should concentrate their efforts on controlling that nominal inflation variable since they cannot systematically influence real variables. These propositions are demonstrated with the aid of the expository model presented in the Appendix on page 21. not output Trade-Offs To summarize, the rationality hypothesis, in conjunction with the natural rate hypothesis, denies the existence of exploitable Phillips curve trade-offs in the short run as well as the long. In so doing, it differs from the adaptive-expectations version of 18 EXPECTATIONS The preceding has shown how the rational expectations assumption combines with the natural rate hypothesis to yield the policy-ineffectiveness conclusion that no Phillips curves exist for policy to exploit and employment. No Exploitable OF RATIONAL ones) ECONOMIC 9 Note that the rational expectations hypothesis also rules out the accelerationist notion of a stable trade-off between unemployment and the rate of acceleration of the inflation rate. If expectations are formed consistently with the way inflation is actually generated, the authorities will not be able to fool people by accelerating inflation or by Indeed. no accelerating the rate of acceleration. etc. systematic-policy will work if expectations are formed consistently with the way inflation is actually generated in the economy. REVIEW, MARCH/APRIL 1985 even in the short run. Given the importance of the rational expectations component in modern Phillips curve analysis, an evaluation of that component is now in order. One advantage of the rational expectations hypothesis is that it treats expectations formation as a part of optimizing behavior. By so doing, it brings the theory of price anticipations into accord with the rest of economic analysis. The latter assumes that people behave as rational optimizers in the production and purchase of goods, in the choice of jobs, and in the making of investment decisions. For consistency, it should assume the same regarding expectational behavior. In this sense, the rational expectations theory is superior to rival explanations, all of which imply that expectations may be consistently wrong. It is the only theory that denies that people make systematic expectation errors. Note that it does not claim that people possess perfect foresight or that their expectations are always accurate. What it does claim is that they perceive and eliminate regularities in their forecasting mistakes. In this way they discover the actual inflation generating process and use it in forming price expectations. And with the public’s rational expectations of inflation being the same as the mean value of the inflation generating process, those expectations cannot be wrong on average. Any errors will be random, not systematic. The same cannot be said for other expectations schemes, however. Not being identical to the expected value of the true inflation generating process, those schemes will produce biased expectations that are systematically wrong. Biased expectations schemes are difficult to justify theoretically. Systematic mistakes are harder to explain than is rational behavior. True, nobody really knows how expectations are actually formed. But a theory that says that forecasters do not continually make the same mistakes seems intuitively more plausible than theories that imply the opposite. Considering the profits to be made from improved forecasts, it seems inconceivable that systematic expectational errors would persist. Somebody would surely notice the errors, correct them, and profit by the corrections. Together, the profit motive and competition would reduce forecasting errors to randomness. Criticisms of the Rational Expectations Approach Despite its logic, the rational expectations hypothesis still has many critics. Some still maintain that expectations are basically nonrational, i.e., that most people are too naive or uninformed to formulate unbiased price expectations. Overlooked is the counterargument that relatively uninformed people often delegate the responsibility for formulating rational forecasts to informed specialists and that professional forecasters, either through their ability to sell superior forecasts or to act in behalf of those without same, will ensure that the economy will behave as if all people were rational. One can also note that the rational expectations hypothesis is merely an implication of the uncontroversial assumption of profit (and utility) maximization and that, in any case, economic analysis can hardly proceed without the rationality assumption. Other critics insist, however, that expectational rationality cannot hold during the transition to new policy regimes or other structural changes in the economy since it requires a long time to understand such changes and learn to adjust to them. Against this is the counterargument that such changes and their effects are often foreseeable from the economic and political events that precede them and that people can quickly learn to predict regime changes just as they learn to predict the workings of a given regime. This is especially so when regime changes have occurred in the past. Having experienced such changes, forecasters will be sensitive to their likely future occurrence. Most of the criticism, however, is directed not at the rationality assumption per se but rather at another key assumption underlying its policyineffectiveness result, namely the assumption of no policymaker information or maneuverability advantage over the private sector. This assumption states that private forecasters possess exactly the same information and the ability to act upon it as do the authorities. Critics hold that this assumption is implausible and that if it is violated then the policy ineffectiveness result ceases to hold. In this case, an exploitable short-run Phillips curve reemerges, allowing some limited scope for systematic monetary policies to reduce unemployment. For example, suppose the authorities possess more and better information than the public. Having this information advantage, they can predict and hence respond to events seen as purely random by the public. These policy responses will, since they are unforeseen by the public, affect actual but not expected inflation and thereby change unemployment relative to its natural rate in the (inverted) Phillips curve equation UN-U=(l/a)(p-pe). Alternatively, suppose that both the authorities and the public possess identical information but that FEDERAL RESERVE BANK OF RICHMOND 19 the latter group is constrained by long-term contractual obligations from exploiting that information. For example, suppose workers and employers make labor contracts that fix nominal wages for a longer period of time than the authorities require to change the money stock. With nominal wages fixed and prices responding to money, the authorities are in a position to lower real wages and thereby stimulate employment with an inflationary monetary policy. In these ways, contractual straints are alleged to create output- stimulating policies. and informational opportunities Indeed, such constraints as into rational to the one Proponents of the rational expectations approach, however, doubt that such constraints can restore the potency of activist policies and generate exploitable Phillips curves. They contend that policymaker information advantages cannot long exist when government statistics are published immediately upon collection, when people have wide access to data through the news media and private data services, and when even secret policy changes can be predicted from preceding observable (and obvious) economic and political pressures. Likewise, they note that fixed contracts permit monetary policy to have real effects only if those effects are so inconsequential as to provide no incentive to renegotiate existing contracts or to change the optimal type of contract that is negotiated. And even then, they note, such monetary changes become ineffective when the contracts expire. More precisely, they question the whole idea of fixed contracts that underlies the sticky wage case for policy activism. They point out that contract duration is not invariant to the type of policy being pursued but rather varies with it and thus provides a weak basis for activist fine-tuning. Finally, they insist that such policies, even if effective, are inappropriate. In their view, the proper role for policy is not to exploit informational and contractual constraints to systematically influence real activity but rather to neutralize the constraints or to minimize the costs of adhering to them. Thus if people form biased price forecasts, then the policymakers should publish unbiased forecasts. And if the policy authorities have informational advantages over private individuals, they should make that information public rather than attempting to exploit the advantage. That is, if information is costly to collect and process, then the central authority should gather 20 ECONOMIC the authorities ment costs general In should by following price if contractual short, advocates argue sufficient justification tational policies of the price that then adjust- stabilize rational that feasibility alone for activist the errors. real activity in- Policies Activist policies since their effective- people into making The proper information expectations constitutes policies. beneficial. also be socially influence reduce these level. approach should minimize ness is based on deceiving stabilization expectations Phillips curve models similar outlined in the Appendix of this article. Finally, wages and prices are sticky and costly to adjust, hardly satisfy this latter criterion and employment- for systematic critics have tried to demonstrate much by incorporating con- it and make it freely available. expec- role for policy is not to via deception deficiencies, but rather to eliminate to erratic variations of the variables under the policymakers’ control, and perhaps also to minimize the costs of adjusting prices. VII. CONCLUDING The preceding paragraphs COMMENTS have traced the evolu- tion of Phillips curve analysis. The chief conclusions can be stated succinctly. The Phillips curve concept has changed radically over the past 25 years as the notion of a stable enduring trade-off has given way to the policy-ineffectiveness view that no such tradeoff exists for the policymakers to exploit. Instrumental to this change were the natural rate and rational expectations hypotheses, respectively. The former says that trade-offs arise solely from expectational errors while the latter holds that systematic macroeconomic stabilization policies, by virtue of their very predictability, cannot possibly generate Taken together, the two hypotheses such errors. imply that systematic demand management policies are incapable of influencing real activity, contrary to the predictions of the original Phillips curve analysis. On the positive side, the two hypotheses do imply that the government can contribute to economic stability by following policies to minimize the expectational errors that cause output and employment to deviate from their normal full-capacity levels. For example, the authorities could stabilize the price level so as to eliminate the surprise inflation that generates confusion between absolute and relative prices and that leads to perception errors. Similarly, they could direct their efforts at minimizing random and erratic variations in the monetary variables under their control. In so doing, not only would they lessen the REVIEW, MARCH/APRIL 1985 number of forecasting mistakes that induce deviations from output’s natural rate, they would reduce policy uncertainty as well. Besides the above, the natural rate-rational expectations school also notes that microeconomic structural policies can be used to achieve what macro demand policies cannot, namely a permanent reduction in the unemployment rate. For, by improving the efficiency and performance of labor and product markets, such micro policies can lower the natural rate of unemployment and shift the vertical Phillips curve to the left. A similar argument was advanced in the early 1960s by those who advocated structural policies to shift the Phillips curve. It is on this point, therefore, that one should look for agreement between those who still affirm and those who deny the existence of exploitable inflation-unemployment trade-offs. APPENDIX A SIMPLE ILLUSTRATIVE The policy ineffectiveness proposition discussed in Section V of the text can be clarified with the aid of a simple illustrative model. The model consists of four components, namely an (inverted) expectationsaugmented Phillips curve (1) UN-U a monetarist (2) = inflation-generating function or feedback control rule = c(U-1-UT)-d(p-l-pT)+µ, and a definition (4) pe mechanism p = m+ a policy reaction (3) m (l/a)(p-pe), = of rational inflation expectations E[p¦I]. Here U and UN are the actual and natural rates of unemployment, p and pe the actual and expected rates of inflation, m the rate of nominal monetary growth per unit of real money demand (the latter assumed to be a fixed constant except for transitory disturbances), and µ are random error terms with mean values of zero, E is the expectations operator, I denotes all information available when expectations are formed, and the subscripts T and -1 denote target and previous period values of the attached variables. Of these four equations, the first expresses a tradeoff between unemployment (relative to its natural level) and surprise (unexpected) inflation.l Equation 2 expresses the rate of inflation p as the sum of 1 There exists a current dispute over the proper interpretation of the Phillips curve equation 1. The rational expectations literature interprets it as an aggregate supply function stating that firms produce the normal capacity level of output when actual and expected inflation are equal but produce in excess of that level (thus pushing U below U,) when fooled by unexpected inflation. This view holds that firms mistake unanticipated general price increases for rises in the particular (relative) prices of their own products. Surprised by inflation, MODEL the growth rate of (demand adjusted) money m and a random shock variable having a mean (expected) value of zero. In essence, this equation says that inflation is generated by excess money growth and transitory disturbances unrelated to money growth. Equation 3 says that the policy authorities set the current rate of monetary growth in an effort to correct last period’s deviations of the unemployment and inflation rates from their predetermined target levels, UT and PT. Also, since money growth cannot be controlled perfectly by the feedback rule, the slippage is denoted by the random variable µ with a mean of zero that causes money growth to deviate unpredictably from the path intended by the authorities. Note that the disturbance term µ can also represent deliberate monetary surprises engiFinally, the last neered by the policy authorities. equation defines anticipated inflation pe as the mathematical expectation of the actual inflation rate conditional on all information available when the expectation is formed. Included in the set of available information are the inflation-generating mechanism, the policy reaction function, and the values of all past and predetermined variables in the model. To derive the policy ineffectiveness result, first calculate mathematical expectations of equations 2 and 3. Remembering that the expected values of the random terms in those equations are zero, this step yields the expressions they treat the price increase as special to themselves and An alternative interpretation views so expand output. the equation as a price-setting relation according to which businessmen, desiring to maintain their constant-marketshare relative prices, raise their prices at the rate at which they expect other businessmen to be raising theirs and then adjust that rate upward if demand pressure appears. Either interpretation yields the same result: expectational errors cause output and unemployment to deviate from their natural levels. The deviations disappear when the errors vanish. FEDERAL RESERVE BANK OF RICHMOND 21 (5) pe = me and (6) me = c(U-1-UT)-d(p-1-pT) which state that, under rational expectations and systematic feedback policy rules, the anticipated future rate of inflation equals the expected rate of monetary growth which in turn is given by the deterministic (known) component of the monetary policy rule. The last step is to substitute equations 2, 3, 5, and 6 into equation 1 to obtain the reduced form expression which states that deviations of unemployment from its natural rate result solely from inflation surprises caused by random shocks. To see the policy ineffectiveness result, note that only the unsystematic or unexpected random component of monetary policy, m-me=µ, enters the the reduced form equation.2 The systematic com- ponent is absent. This means that systematic (rulesbased) monetary policies cannot affect the unemployment rate. Only unexpected money growth matters. No Phillips curve trade-offs exist for systematic policy to exploit.3 To summarize, market model depicted are the only equilibrium, 22 ECONOMIC to systematic variables will wage/price dictable vails and like be fully adjustments. random surprises, that expectational errors that such errors on policies rate of departure that rules-based be exploited are random, short-lived, policy manipulation, unemployment and since those foreseen and allowed for in Thus, except for unpre- monetary impacts on real economic by unforeseeable steady-state policies can have no impact no disappointed are totally from shocks, steady-state systematic price, continuous expectations-natural here implies therefore real (flexible rational source and immune curves 2 Note that both the monetary-surprise equation m-me=µ and the price-surprise equation p-pe= embody the famous orthogonality property according to which forecast errors m-me and p-pe are independent of (orthogonal to) all information available when the forecast is made. In particular, the forecast errors are independent of the past and predetermined values of all variables and of the systematic components of the policy rule and inflation-generating mechanism. This is as it should be. For if the errors were not independent of the foregoing variables, then information is not being fully exploited and expectations are not rational. the strict clearing) random changes expectations, variables. adventitious by systematic equilibrium produce preno no transitory In short, Phillips phenomena generated shocks and as such cannot policy even in the short run. 3 Of course random policy could affect output. That is, the authorities could influence real activity by manipulating the disturbance term µ in the policy reaction funcRandomness, tion in a haphazard unpredictable way. however, is not a proper basis for public policy. REVIEW, MARCH/APRIL 1985 INFLATIONARY EXPECTATIONS, MONEY GROWTH, ANDTHEVANISHING LIQUIDITY EFFECTOF MONEY ON INTEREST:A FURTHER INVESTIGATION Yash Mehra* I. INTRODUCTION An important issue in discussion of the transmission mechanism of monetary policy is the response pattern of nominal interest rates to changes in the growth rate of money. The traditional analysis of the effects of changes in money growth on nominal interest rates runs in terms of liquidity, income, and Consider an increase in the expectations effects.l growth rate of money. Initially, there is an excess supply of money at the existing income, interest rate, and the price level. If the price level and real income adjust slowly, then the nominal interest rate must decline in order to equate money demand and money supply. This initial fall in the nominal and real2 interest rates is known as the liquidity effect. Over time, nominal income will rise following the increased growth rate of money and this rise in nominal income will increase money demand which in turn leads to higher interest rates. This is the income effect of money on the nominal interest rate. Finally, there is a Fisher or expectations effect as nominal interest rates increase due to a rise in inflationary expectations induced by the higher money growth rate.3 * Economist and Research Officer, the Federal Reserve Bank of Richmond. The views expressed here are those of the author and do not necessarily reflect the views of the Federal Reserve Bank of Richmond or the Federal Reserve System. Tom Hahn provided excellent research assistance. 1 Friedman dolfi (1969, and Melvin (1968, 1969), Cagan (1972), Cagan and GanGibson (1970), Darby (1975), Carlson (1979), (1983). 2 If the price level and inflationary slowly, a reduction in the nominal reduction in the real rate. expectations interest rate adjust implies 3 If the higher level of inflationary expectations has no effect upon the steady state value of the real rate, then, the nominal interest rate will rise by the full amount of the rise in inflationary expectations. An avenue through which higher money growth can affect the real rate is discussed in Mundell (1963). The important assumption underlying this description of the time pattern of the effects of higher money growth on interest rates is that income and expectations effects of a current acceleration in money growth occur with a lag as the income and the price level are slow to adjust. If this assumption is not valid, for example, if the expectations effect of higher money growth occurs rapidly or if there is a reduction in the lag in the effect of money on income, the liquidity effect will not be observable. The early empirical work which examined the time pattern of the effects of higher money growth on interest rates seemed to confirm the previously deIn particular, this work scribed stylized pattern. showed the presence of a statistically significant liquidity effect.4 However, the results of more recent empirical work on this issue have been mixed.5 Mishkin (1981, 1982) recently suggested that the liquidity effect of money on interest did not exist, and Melvin’s (1983) work implies that the liquidity effect existed in the ’50s and the ’60s but vanished in the ’70s. Makin (1983) on the other hand, reports evidence consistent with the presence of a statistically significant but quantitatively weak liquidity effect.6 This paper has two objectives. The first objective is to investigate further the existence of the liquidity effect using an improved estimation methodology. 4 Gibson (1972). 5 Mishkin (1970), Cagan and Gandolfi (1969), and Cagan For a recent confirmation, see Melvin (1983). (1981, 1982), Melvin (1983), and Makin (1983). 6 In Makin’s framework, only unanticipated increases in money growth can depress nominal and real interest rates. Anticipated increases in money growth are not at Moreover, all associated with declines in interest rates. the magnitude of the reduction in interest rates associated with a given positive money surprise is very small. A positive money surprise over a quarter at a 1 percent annual rate depresses the short-term interest rate by 2 to 3 basis points. This implies that if the Fed wants to depress short-term interest rates by 100 basis points in a given quarter, then positive money surprises over a quarter at a 33 percent to 50 percent annual rate are needed. FEDERAL RESERVE BANK OF RICHMOND 23 The existing empirical work employs the questionable assumption that the money growth variable is strictly an exogenous regressor.7 This is a questionable assumption in view of the way that monetary policy has been conducted. Policy has been aimed at fostering the attainment of macroeconomic objectives such as sustained economic growth, full employment, and low inflation. But in seeking to achieve these objectives, the Federal Reserve has used as guides such financial variables as the monetary aggregates and money market interest rates. Over much of the last three decades, considerable weight has been given to money market conditions and to dampening swings in interest rates. Furthermore, in more recent periods when greater weight has been placed on the monetary aggregates, financial innovations and deregulation of the financial markets occasionally have combined to make money demand a less useful guide to monetary policy, thus forcing the Federal Reserve to place added emphasis on interest rates at the expense of the monetary aggregates. In view of the above considerations, the money growth variable is likely to be correlated with the disturbance term in the usual nominal interest rate regressions. The use of ordinary least squares to estimate the time pattern of the effects of higher money growth on interest rates, therefore, may provide inconsistent estimates of the existence of the liquidity effect. This paper uses a consistent estimation procedure to investigate the existence of the liquidity effect. The second objective of this paper is to provide some empirical evidence on Milton Friedman’s view (1968) that the presence of the liquidity effect of higher money growth depends upon the nature of the response of expected inflation to higher money growth. Friedman (1968) has argued that in a high inflationary environment, inflationary expectations become so responsive to money growth that the expectations effect may be strong enough and prompt enough to overpower the short-run liquidity effect. Since the United States experienced rising inflation in the late ’60s and the ’70s Friedman’s argument 7 In a regression equation, a right-hand side explanatory variable is not exogenous if it is contemporaneously correlated with the disturbance term. In that case, the use of ordinary least squares to estimate the regression parameters will produce estimates which have some undesirable properties. In particular, the estimates will be inconsistent meaning they do not converge to the true values of the parameters as the sample size becomes very large. Therefore, the ordinary least squares estimation procedure is an inconsistent estimation procedure in the presence of an endogenous regressor in the regression equation. However, there exists alternative estimation procedures which can produce consistent estimates of the parameters. Such estimation procedures are sometimes referred to as consistent estimation procedures. 24 ECONOMIC would imply a reduction in the magnitude of the liquidity effect during that time period. This implication will be tested in this paper. The rest of the paper is organized as follows. Section II presents a simple model of interest rate determination and defines the liquidity effect in the context of this model. It discusses the relevance of the nature of the monetary policy regime in getting consistent estimates of the parameter measuring the existence of the liquidity effect. It also reviews the argument made by Friedman (1968), noted above. Section III reports the empirical results, and Section IV contains the main conclusions and some policy implications. II. EXPLANATION OF METHODOLOGY A Model of Interest Rate Determination, the Liquidity Effect, and the Behavior of the Federal Reserve Economists have long been interested in investigating the time pattern of the effects of money growth on nominal and real interest rates. The analytical framework that underlies the empirical investigation differs widely among these economists. However, in each case, inferences about the existence of the liquidity effect are based upon a nominal interest rate regression in which money growth appears either as the sole regressor or as one of the right-hand side regressors.8 A common assumption made in this 8 Basically, three approaches have been used to study this issue. One of these is to estimate distributed lag regressions of nominal interest rates on money growth by ordinary least squares and to infer the existence and strength of the liquidity effect from examining the sign and size of the coefficients on the first few lags of the money growth variable; here money growth is-the only right-hand side explanatory variable (Melvin (1983)). The second approach employed is to specify explicitly an IS-LM-Aggregate Supply model of the economy and estimate by ordinary least squares the associated reduced form for the nominal interest rate. In this framework, money growth is only one of the right-hand side regressors, which also include a proxy for expected inflation. The presence of the liquidity effect is inferred by examining the sign and size of the coefficient on the money growth variable (Makin (1983), Peek and Wilcox (1984)). The third approach uses the efficient marketsrational expectations theory. If bond markets are assumed to be efficient, then nominal yields will deviate from their equilibrium values only when new information In this framework, changes appears on the market. in nominal yields are regressed upon surprise (i.e., actual minus anticipated) changes in information variables like money growth, inflation, real income, and the presence of the liquidity effect is inferred by examining the sign and size of the coefficient on the surprise money growth variable (Mishkin (1981, 1982)). Here money growth again is one of the right-hand side regressors. REVIEW, MARCH/APRIL 1985 empirical work, that money growth is an exogenously determined variable, allows one to use ordinary least squares to estimate the parameters of the nominal interest rate regressions. As noted above, this assumption is questionable in view of the way the Federal Reserve has conducted its monetary policy.9 In order to explain the issues involved as well as motivate the empirical work reported here, this paper investigates the existence of the liquidity effect using the most widely proach to interest proach amounts equation employed rate augmented Phillips by some sort relation. coefficient variable in the associated effect. Aggregate Consider Supply ap- Fisher of the real rate of Aggregate The appearing used to infer the existence quidity the standard the determinants ap- This specified by means of an IS-LM curve estimated equation) determination.10 to estimating in which are explicitly (Fisher model Supply or sign and size of the on the money growth Fisher equation and magnitude the following is then of the li- simple IS-LM- model:11 9 There is another set of very recent papers which looks at the responses of asset prices (or nominal asset yields) to the weekly money stock announcements (Urich (1982, 1984), Grossman (1981), Cornell (1982, 1983a, 1983b), and Gavin and Karamouzis (1984)). In these studies, changes in asset prices are generally regressed upon surprise changes in the weekly money stock numbers. There are two important assumptions underlying this work. The first is that the weekly money stock numbers have a predictive content for the future money stock. The second is that the asset markets are efficient and that the asset prices will respond to any new information contained in these money stock announcements. It is then argued that the predictive content of money stock announcements and the response of asset prices to new information in the announcements vary with changes in the way the Federal Reserve formulates and implements the monetary policy. The implication is that changes in the response of asset prices- to money stock announcements can enable us to infer the public’s perception of the policy making. Since the money announcement studies focus on explaining changes in asset prices in the very short runthe period immediately following the announcement-and since information about other potentially related factors is not included in these regressions, one could not necessarily infer the existence of the liquidity effect from examining the sign of the estimated regression coefficient on the money announcement variable in a given asset price regression. 10 Sargent (1972), Levi Wilcox (1983), Makin (1984). and Makin (1978), (1983), and Peek Peek and (1982), Wilcox 11 This macromodel is in essence similar to the ones given in Peek (1982), and Wilcox (1983). For a detailed description, see Mehra (1984). AS : P = c0 + Pe + cl (Y-Yn) c2SS + + U3t, c1, c2 > 0, (3) where all the variables except i and Z are in natural logs and where Y is actual real output, Yn is the natural real output, X is the exogenous component of aggregate real demand, M is the nominal money stock, P is the price level, Pe is the expected price level, i is the nominal interest rate, SS is the supply shock variable measuring the relative price of energy, Z is the percentage change in-teal output lagged one period, T is the average marginal tax rate on interest income, and Us, s = 1,2,3, are stochastic error terms.13 Figure 1 presents graphs of the IS, LM, and aggregate supply (AS) equations. Equation (1) is the equation of the IS curve showing an inverse relationship between the after-tax nominal rate i(1-T) and real output (Y-Yn); its position depends upon the exogenous component of the real demand X, the expected inflation rate , the lagged growth in real income Z, and the supply shock variable SS. Equation (2) is the equation of the LM curve showing a positive relationship between the after-tax nominal rate i(1-T) and real output (Y-Yn); its position depends upon the price level P and the nominal money stock M. Equation (3) is the equation of the aggregate supply curve implying a positive relationship between the price level and real output; its position depends upon the expected price level Pe and the supply shock variable SS. U1, U2, and U3, 12 The demand equation for real money balances lying the LM curve is assumed to be (M-P-Yn)d b0 + b1(Y-Yn)-b2 i(1-T). Assuming that the supply -equals money demand, we can solve the rium expression for the after-tax nominal interest get equation (2) of the text. under= money equilibrate to 13 X captures the effects of changes in the autonomous components of aggregate real demand such as real exports and real government expenditures. Z proxies for the effect of income induced investment expenditures, the so-called investment accelerator effect. SS captures the The effect of changes in the relative price of energy. model is short run in nature and focuses on the cyclical behavior of the economy. Therefore, actual real output is measured relative to its natural level, and some other For example, X is variables are similarly normalized. normalized dividing it by the natural real output. In this context, pe is to be viewed as the expectation held at time t-l of the price level at time t. Actual real output will deviate from its natural level whenever the actual price level (P) differs from its anticipated level (Pe) (see equation (3) in the text). FEDERAL RESERVE BANK OF RICHMOND 25 respectively, are the stochastic error terms appearing in the IS, LM, and AS relationships. In order to derive the Fisher equation associated with this macromodel, we can combine equations (1) through (3) to get the following: where DMt is (M-Pe-Yn), and where A1, A2, A3, A4, and A5 are the parameters in the nominal interest The stochastic term Vt in (4) is rate equation.14 the reduced form disturbance term and is related to the stochastic terms appearing in the IS, LM, and AS relationships in the following way: where It can be easily shown15 that in the nominal interest rate equation (4), the nominal interest rate responds positively to increases in expected inflation (A5 > 0), the exogenous component of real demand (A1> 0), and real income (A4 > 0). The supply stock variable has an uncertain effect upon the nominal interest rate (A2 0). The coefficient in front of the money stock variable is negative (A3 < 0), implying that higher money stock depresses the nominal interest rate. Equation (5) is important for the later discussion as it shows that the stochastic shifts occurring in the IS, LM, and AS relationships can cause stochastic shifts in the nominal interest rate equation (4) and thus cause the actual nominal interest rate to deviate in the short run from the value implied by the behavior of expected inflation, autonomous real demand, relative price of energy, and money stock. In this framework, the existence of the liquidity effect is investigated by examining the statistical significance of the parameter A3, which is usually estimated with ordinary least squares. The main question is whether it is appropriate to 14 Equation (4) is the standard Fisher equation adjusted to allow for the presence of taxes. To see this, rewrite (4) as where is the after-tax expected real rate assumed approximated by the following relationship (b) rte = (1/(1-T)) [A0 + A3 DMt + A4 Zt. A1 Xt + A2 SS to be + Equation (a) is the standard Fisher equation as one can view rte as the expected real rate component of the nominal interest rate. 15 For 26 details, see Mehra (1984). ECONOMIC estimate the nominal interest rate equation (4) by the ordinary least squares estimation procedure. If any one of the right-hand side explanatory variables appearing in (4) is correlated with the error term Vt, then the ordinary least squares estimates of the parameters are inconsistent and this may yield an incorrect inference about the existence of the liquidity Of interest here is the possibility that the effect. error term Vt may be correlated with the money growth variable due to the way the Federal Reserve implements its monetary policy. Consider the case in which the Federal Reserve conducts monetary policy by focusing solely on the monetary aggregates. In this case, any random rise in the nominal interest rate (Vt > 0) as a result of a REVIEW, MARCH/APRIL 1985 random shift occurring in the IS, the LM, or the AS relationship is not offset by the Federal Reserve letting money growth (M) deviate from its targeted value. Here, the money growth variable is likely to be predetermined and not correlated with the error term Vt. However, if the Federal Reserve, though still focusing on the monetary aggregates, does partially smooth interest rates, then a positive correlation between DMt and Vt may exist. Consider, for example, a stronger than expected increase in the exogenous component of real demand causing an upward random shift in the IS relation (U1t > 0). It is clear from equation (5) that a positive shock in the IS relation will cause a positive shock (Vt > 0) in the nominal interest rate equation (4). This will cause If the Federal the nominal interest rate to rise. Reserve decides to prevent or reduce the extent of this rise, it would let the money stock (M) rise and thereby create a positive covariance between DMt and Vt.16 In this case, it can be easily shown that the ordinary least squares estimation procedure will generate an inconsistent estimate of the liquidity effect parameter A3.17 The extent of the least squares bias in the estimate of the liquidity effect parameter in equation (4) becomes more severe if the Federal Reserve conducts monetary policy focusing on interest rates. In the limiting case in which the Federal Reserve fixes a nominal rate and stands ready to maintain it, a regression equation like (4) is not relevant. This is so because the nominal rate is predetermined in this case, and the nominal money stock simply responds to any discrepancy between the actual and the targeted value of the nominal interest rate. In fact, if the Federal Reserve is successful in this interest rate pegging policy, the regression of the nominal rate on the right-hand side explanatory variables as in (4) should yield a coefficient on the money growth variable which is not statistically different from zero.18 The basic point is further illustrated in Figure 2 which shows an initial equilibrium point A in the IS-LM diagram. Consider a positive stochastic shock to the IS relationship, arising, say, from a stronger than anticipated increase in the aggregate demand. This shock causes the IS curve to shift upward, moving the (partial) equilibrium point from A to B 18 In this case, the nominal interest rate regression like (4) is likely to be viewed as representing possibly the reaction function of the Federal Reserve. Therefore, the response of the nominal interest rate to variables other than money growth will depend upon the time period for which the interest rate is pegged and the considerations which cause the Federal Reserve to change the rate it pegs. 16 It should be kept in mind that the correlation between DMt and Vt is mainly due to correlation between Mt and Vt. 17 The nature of the bias in the estimated parameter is likely to be positive. This point can be easily demonstrated. Consider the following simple version of the interest rate equation it = a + bMt + cPt + Vt, where i is the nominal interest rate, M is the money growth variable, P stands for other variables appearing The in the equation, and V is the disturbance term. parameter b is hypothesized to be negative, and it measures the liquidity effect. If this equation is estimated by ordinary least squares, it can be shown that the probability limit (plt) of the least squares estimate of b can be expressed as : plt(b) = [b + (COV(M,V) COV (P,V) COV COV (P,P) (M,P))/(D)I, - where D is [COV(M,M) COV(P,P) COV(M,P)2] COV (M,V) is the covariance between M and V, and COV(P,P) is the variance of P. Other terms can be interpreted in a similar fashion. If the explanatory variables are contemporaneously uncorrelated with the error term V (COV (M,V) = COV (P,V) = 0), it is clear that plt(b) equals b, and the above regression provides a consistent estimate of the liquidity effect. But suppose that M and V are positively correlated, then it is clear that plt(b) equals [b + (COV (M,V) COV(P,P))/ (D)]. Since both D and COV(P,P) are positive, the presence of the positive covariance between M and V causes a bias in the estimate of the liquidity effect parameter. All variables are as defined the stochastic and stock. is the M2 and targeted level M3 actual money stock, M3 > FEDERAL RESERVE BANK OF RICHMOND in the text. U1t is error term in the IS relationship, are M2 > of the levels money of the . 27 and resulting in upward pressure on the after-tax nominal interest rate. If the Federal Reserve does not smooth interest rates, the actual money stock stays at the targeted level. But if the Federal Reserve does smooth interest rates, it may let the actual money stock rise to M2, resulting in a new equilibrium at point C in Figure 2. At this point, we have a higher money stock and a higher level of the after-tax nominal interest rate (compare A and C in Figure 2). On the other hand, if the Federal Reserve decides to eliminate completely the rise in the nominal interest rate, it may cause the money stock to rise enough to yield the equilibrium point D shown in Figure 2. Here, we have higher money stock (M3 > ) accompanied by no important change in the nominal interest rate. Thus, a positive stochastic shock to the IS relationship combined with a partial smoothing of interest rates creates a positive correlation between money and the error term in the nominal interest rate regression. Inflationary Expectations and Money Growth: Is the Liquidity Effect Temporally Stable? An important assumption underlying the existence of the liquidity effect is that the price level and real income do not adjust fully as the money supply changes. In the context of the present model higher money growth is associated with a reduction in the nominal interest rate (A3 < 0 in equation (4)) provided the expected inflation rate variable is not immediately affected by the current acceleration in money growth. If the expectations effect of higher money growth occurs rapidly, then higher money growth may not depress the nominal interest rate, even in the short run. siderations, one may expect to find a) an increase in the responsiveness of inflationary expectations to higher money growth, and b) a decrease in the magnitude of the liquidity effect over time. Empirical evidence on these issues is provided by examining the temporal stability of the liquidity effect parameter A3 in the nominal interest rate equation (4). Since the empirical work in this paper uses the Livingston survey measure of expected inflation as a proxy for inflationary expectations, the Livingston measure’s sensitivity to higher money growth over time can also be examined. III. EMPIRICAL RESULTS This section reports the empirical results concerning the existence, magnitude, and temporal stability of the liquidity effect. In order to examine the sensitivity of inflationary expectations to higher money growth, equations explaining the formation of inflationary expectations are reported and their stability over time is investigated. In an attempt to capture empirically the liquidity effect of money on interest rates, the monetary variable is measured in growth form and is represented by the current growth rate of the nominal money stock relative to its most recent trend growth rate. It is these accelerations or decelerations in nominal money growth relative to normal that are likely to affect the real interest rate and generate the liquidity effect. Changes in the nominal money stock induced by a constant trend growth rate of money are likely to be reflected in prices and hence are likely to leave unchanged the real rate.19 As stated before, the short-term U. S. monetary policy stance has been constrained by, among other things, the Federal Reserve’s concern to promote a stable environment in the financial markets.20 This As noted before, Friedman (1968) has argued that the liquidity effect of higher money growth will not be found in countries which have long experienced high inflation. His point is that in a high inflationary environment, inflationary expectations will become more responsive to money growth and the expectations effect of higher money growth will therefore occur rapidly. 19 Cagan and Gandlofi (1969), Gibson (1970), and Melvin (1983). See also Carlson (1979) and Wilcox (1983) who It should be employ this measure of money growth. noted that the money stock variable is not divided by the expected price level and the natural real output. In order to investigate the empirical validity of Friedman’s argument, this paper examines the temporal stability of the liquidity effect. The average U. S. inflation rate observed in the late ’60s and the ’70s was certainly higher than that observed in the ’50s and the early ’60s. Moreover, there has also occurred an increased awareness of the role of money growth in causing inflation. In view of these con- 20 For a description of how the Federal Reserve’s ongoing desire to avoid disorderly conditions in financial markets shaped monetary policy in the ‘50S, the ‘60s, and the early ‘70s, see Lombra and Torto (1975). For some empirical evidence on the same issue, see De Rosa and Stern (1977), Feige and McGee (1979), and the references cited in them. For a more recent review of U. S. monetary policy, see Poole (1982) and Axilrod (1985). The paper by Axilrod (1985) provides a good discussion of several other exogenous forces that might have led the Federal Reserve to deemphasize the monetary aggregate (M1) in the short-run formulation of monetary policy. 28 ECONOMIC REVIEW, MARCH/APRIL 1985 concern has led the Federal Reserve at various times to dampen fluctuations in interest rates. Hence the money growth variable in the nominal interest rate regression (4) is likely to be correlated with the error term. The interest rate regressions reported in this paper are therefore estimated employing an instrumental variable estimation procedure.21 However, the coefficient measuring the effect of accelerations in money growth on the nominal interest rate (coefficient on LIQ in Table I) is negative but statistically insignificant at the conventional significance level. The estimates based on the full sample periods therefore do not support the presence of a statistically significant liquidity effect. Table I reports estimates of the nominal interest rate equation (4) for two sample periods 1952-1979 and 1952-1983. These estimates, which are obtained using the instrumental variable estimation procedure with a first-order serial correlation correction, imply that most of the explanatory variables have the expected influence on the behavior of the nominal interest rate. That is, rises in expected inflation (PE12), exogenous components of aggregate demand (X), and lagged real income growth (Z) raise interest rates while positive supply shocks (SS) lower them. (See coefficients on these variables in Table I).22 Table II reports estimates of the nominal interest rate equation over various subperiods. In order to separate the earlier, low-inflation period from the high-inflation period which starts in the mid-‘60s, the full sample period is split at the end of 1965 and the estimates of the interest rate equation so obtained are presented in rows 1, 3, and 4. Melvin (1983) interest rate. Secondand fourth-quarter observations are used for the variables measuring the exogenous component of aggregate demand (X), supply shocks (SS), and real income growth (Z). X is the logarithm of the sum of real exports and real government expenditure on goods and services divided by the level of natural real output. The Rasche-Tatom series on the potential GNP constructed at the Federal Reserve Bank of St. Louis is used as a proxy for the natural real output. SS is constructed by taking the ratio of the deflator for imports to the GNP deflator and multiplying this ratio by the nominal effective dollar exchange rate index constructed by the Morgan Guaranty Trust. The latter step eliminates the effect of exchange rate changes on the import Z is the percentage change in the real GNP deflator. lagged one quarter. The data on the LIQ variable were generated using June and December observations on Ml according to the following relationship: 21 The basic idea behind the instrumental variable estimation procedure is to seek out the variables-called instruments-which are correlated with the endogenous variable in question but not correlated with the error term in the regression equation. The instruments are then used to generate estimates of the regression parameters, which are generally consistent. 22 The data used are semiannual observations corresponding to the Livingston survey data collected each June and December. Monthly averages of l-year Treasury bill yield during June and December are used for the nominal LIQ = ((Mt/Mt-1)2-l)-((Mt-l/Mt-7)1/3-l). Table I ESTIMATES OF THE INTEREST RATE EQUATION, INSTRUMENTAL Notes: The nominal variables i = -T))[A0+ i is the expenditure, the SS the last average interest lation. zero to The estimated See DW footnote of X, and rate is the reported above A4Z A5PE12], by for is from a credit details 14-month growth rate Joe the text (equation period control statistic, and the LIQ is the the last and (4)) and of real i. The is the includes R2 adjusted serial a for correlation changes growth (Carlson value of and The December. estimation 1952.06-1983.12 is years lagged for annualized procedure, and value adjusted three Z is the variable dummy. normalized horizon, June and the GNP over each LIQ is for instrumental of X deflator (1982), collected values on Peek bill, and the the the + Treasury imports over data lagged equation further for employing survey Durbin-Watson for one-year deflator prepared Z and includes A3LIQ + a its annualized rate and on inflation Livingston it also 22 the is estimated the SS, A2SS + yield of minus tax interest otherwise; regression, months equation PE12, ratio forecast marginal rate of is the six + market survey corresponding values equation A1X average Livingston over the rate DATA, FOR SERIAL CORRELATION can be expressed, using proxy as (1/(1 where interest SEMIANNUAL VARIABLE PROCEDURE WITH A CORRECTION the corrects for dummy which degrees coefficient. data instruments the of freedom, The of used the value SER parentheses of T is the the the the one real current first-order in is the contain PE12 money semiannual are of government rate, nominal 1983), are real exchange growth used presence takes of Wilcox rate and the rate 1979, the exports in series GNP. on The observations and serial lagged corre- 1981.06-1983.12 standard is stock error and of the t values. data. FEDERAL RESERVE BANK OF RICHMOND 29 Table ESTIMATES OF THE INTEREST RATE EQUATION INSTRUMENTAL II OVER VARIOUS SUBPERIODS, SEMIANNUAL VARIABLE PROCEDURE WITH A CORRECTION DATA, FOR SERIAL CORRELATION CoefficientsOn Sample Period 1. 2. 3. 1952.06-1965.12 1952.06-1970.06 1966.06-1979.06 PE12 5. 1966.06-1983.12 1970.12-1979.06 Note: 1970.12-1983.12 See Table Z -17.4 -1.9 (-1.3) 4.3 (1.3) 11.2 (-2.3) .75 -15.1 -2.0 2.7 11.0 (5.7) (-2.9) (-1.6) (1.4) (2.3) .78 -4.5 -4.3 (.6) 11.9 9.1 (3.8) 1.3 .73 -1.6 -4.0 10.0 1.4 (6.7) (-.2) (-3.6) (3.6) (.2) -4.5 .91 6.1 (.5) 13.5 10.3 (-4.0) (1.5) (1.5) 4.4 2.9 .85 -.9 -4.1 (6.9) (-.1) (-3.9) SER .95 .644 2.1/.08 .97 .611 2.1/.08 .99 .684 1.9/.09 .99 .844 2.0/0.0 .99 .622 1.97/-.2 .99 .817 2.1/-.3 (2.0) (-3.9) (.6) (.4) I notes. has argued that a significant change in the response of nominal interest rates to higher money growth occurred in the early ’70s not in the mid-'60s. Rows 2, 5, and 6 present estimates obtained by splitting the sample in 1970.23 The estimates obtained for the coefficient associated with accelerations in money growth in the nominal interest rate equation in the low-inflation period clearly imply the existence of a strong and statistically significant liquidity effect (see the coefficient on LIQ presented in rows 1 and 2 in Table II). These estimates imply that one percent positive deviation in the money growth from its most recent trend growth rate reduces the nominal interest rate by 15 to 17 basis points. However, the estimates obtained for the high-inflation period imply the complete disappearance of this liquidity effect (see the coefficient on LIQ presented in rows 3, 4, 5. and 6 in Table II). There is a drastic reduction in the size of the liquidity effect parameter, and it is never statistically significant. These results together then imply that the liquidity effect is not temporally stable; there does not appear to exist a significant liquidity effect over the 23 It is not the intent of this paper to search for the exact date where there was a significant change in the structure. However, these two ways of splitting the full periods may broadly be viewed as an attempt to separate the low-inflation period from the high-inflation period. 30 X .85 (6.9) 6. SS (3.0) (6.3) 4. LIQ ECONOMIC REVIEW, high inflation the '70s.24 period comprising the mid-'60s and In a high-inflation period, inflationary expectations may adjust rapidly and become more sensitive to higher money growth. Therefore, the money growth variable, when introduced as an additional regressor in a nominal interest rate regression that already contains the variables capturing the expectational (and perhaps real income) effects associated with higher money growth, may not add to the explanatory power of the equation, i.e., there may not be the liquidity effect associated with higher money growth. Since inflationary expectations here are proxied by the Livingston survey measure of the expected inflation rate,25 one may explain the change in the response of the nominal interest rate to higher money 24 It might be pointed out that this result about the temporal instability of the liquidity effect is not due to the use of the instrumental variable estimation procedure. The ordinary least squares estimation of these interest rate equations yields a similar inference about the vanishing of the liquidity effect over the high-inflation period. However, the two estimation procedures yield rather different estimates of the magnitude of the liquidity effect over the low-inflation period. The instrumental variable estimation procedure yields estimates of the liquidity effect which are stronger than those produced by the ordinary least squares procedure. 25 This practice is widespread; see Levi (1978), Carlson (1979), Peek (1982), Makin Peek and Wilcox (1984). MARCH/APRIL 1985 and Makin (1983), and growth in terms of the change that may have occurred in the formation of this survey pected inflation rate. by this survey measure that this Table of the ex- EQUATIONS Is there any evidence to support the view that inflationary and measure expectations are sensitive sensitivity may EXPLAINING INFLATION as measured have increased PARTICIPANTS, SEMIANNUAL DATA 1956.06-1983.12 over Dependent Variables III equations and IV report explaining pectations an attempt the formation to identify agents inflation, Table tion estimates expected Variable: PE12 the presents obtained inflation related rent and past values (3) budget deficits, and (5) supply implies that survey participants of inflation the inflation rate money growth rate. expectations statistic and in explaining prove dramatically The rate, finding (2) that the of the of the made the formation is very impressive; by of infla- both the of the equation when money growth regressor that value contribution error . - .02 pt-1 government potential (measured deficits), containing here by high employment between actual and GNP, and supply shocks do not help explain (2.2) . (7.0) .09 .09 (1.9) (1.8) .31 .31 (6.8) (6.6) -3.2 (-.4) - .02 GAPt (- .4) 1.4 SSt 26 Several other economists have also examined the Livingston survey measure in an attempt to determine how expectations are formed. See Gordon (1979), Mullineaux (1980), Jacobs and Jones (1980), and Gramlich (2983). However, these authors have examined only the short-term forecasts of inflation (six-month). The focus of the present paper is on the twelve-month forecasts of inflation by the survey participants. (1.1) P .34 .91 .87 .86 SER .546 .445 .444 .451 DW 1.92 P 1.0 The Note: tions the general of form = 1.7 1.9 1.9 .5 .6 .6 A(L) rates P, money growth of this the distributed t, B(L)& rates, were equation (4)) are tion procedure. the the FEDERAL RESERVE BANK OF RICHMOND is the expectais of in by added; its various with data data. See on the for See also notes the highGNP variable, GAP measure and the credit generally the policy nominal of and economy ((Y,control insignificant. (equations (1) through serial correlation correc- these regressions is 1956 high-employment year. on fiscal state wage-price t inflation in by time horizon lag shock averaged at past change cyclical were the in the scaled versions made 14-month distributed the year the that lag first-order starting on the supply they a over the the also The by the for $) change deficit ond beginning on i change estimated available of participants forecast is the here here This details the Dummies CS,, survey measuring --approximated YWY”)). formation survey rote government is it, time approximated is a variable periods B(L) &, Livingston is as of &3 the Livingston inflation known (HDJ, CS, it, is the annualized (t+14), explaining the below: f(A(L) PE12 the by given PE12, of equation inflation because derivation 1.4 (1.a employment for an explicit (.4) HDt variable (1983) .02 .30 Mt past 27 See Gramlich equation. .04 (.7) .lO (-.5) .48 (7.4) im- is introduced in an equation the gap .46 (.2) - .03 k-2 - .64 (- 1.9) (8.1) .Ol (.3) where deficits .5l (10.9) (3.8) only the past history of actual inflation (see equations 1 and 2 in Table III). Other variables including budget - .60 (-1.9) expectations and past values the current (4) in these variables in forming The and the standard as an additional of (1) cur- inflation .27 pt of vari- are significant important are the current actual tionary measure expectations of inflation. presented in Table III consider growth equa- that they are used in the forma- most money -.71 of of the money supply, shocks.27 tion of survey participants’ The regression equations imply Constant (4) the cyclical state of the econ- some or all of these variables regressions regression to inflation,-namely of the actual (3) (-2.8) variables on a vector and past rates of growth ex- expectations when the survey is regressed (2) participants.26 important several (1) of the of inflation survey look at in forming III ables plausibly current some estimates by the Livingston economic omy, OF SURVEY Independent Tables In EXPECTATIONS OF THE LIVINGSTON to money growth time? III deficit footnote 29 in IV. Table for is only further 31 this survey measure of expected inflation tions (3) and (4) in Table III).28* 2v If economic agents do consider money growth in forming expectations of inflation, is this relation stable between low-inflation and high-inflation periods? Table IV presents estimates of the expectation formation equation (equation 2 from Table III) for various subperiods obtained as a result of splitting as before the full sample periods. Rows 1 and 2 present estimates obtained for the low-inflation period and rows 3, 4, 5, and 6 present estimates obtained for the high-inflation period. For each subperiod, the coefficient on the money growth variable is positive and statistically significant. However, the point estimates of this coefficient obtained for the high-inflation period are substantially higher than those obtained for the low-inflation period (compare the coefficient on M, in rows 1 through 6 in Table IV). This result could be interpreted to imply that the survey participants, in forming their expectations of inflation, give more weight to money growth when the average inflation rate is high. Furthermore, the size of the (see equa- 28 Several other measures, including the high employment government expenditure and the unemployment rate, were also tried. However, none of these variables entered significantly. In studies of the short-term inflation forecasts, Mullineaux (1980) and Gramlich (1983) also found that fiscal policy-related measures and the measures capturing the cyclical state of the economy (such as the unemployment rate, the GAP measure) did not help explain the formation of inflationary expectations. 2s The data used in these regressions are again semiannual observations corresponding to the Livingston survey data collected each June and December. The data on the (known) past values of actual inflation and money growth are generated using the monthly data on the consumer price index and Ml. In constructing these actual inflation and money growth rates, it is assumed that the Livingston survey participants knew the April values for the CPI and Ml at the time of June survey and the October values at the time of December survey. The annualized growth rates were constructed by usin the following formulas: the June growth rate = ((Aprr 7 Value in the Current Year/the February value in the previous year)Wl4-1); the December growth rate = ((the October value in the current year/the August value m the past year)12/14-1). The quarterly data are used to construct the annual growth rates for variables measuring changes in the fiscal policy and supply shocks, and the first- and second-quarter observations are used in the regessions reported in Table III. The gap measure uses quarterly data natural real output; the latter ceding four quarters. Table ESTIMATES OF THE EFFECT OF MONEY on the real GNP and the are averaged over the pre- IV GROWTH ON INFLATIONARY EXPECTATIONS OVER VARIOUS SAMPLE PERIODS, SEMIANNUAL DATA, THE LIVINGSTON SURVEY MEASURE PE12 Coefficients On . Sample Period constant 1. 1952.06-1965.12 .91 2. 1952.06-1970.06 . pt-1 pt ' .06 (.7) -.12 (-1.8) -.17 (-4.5) .07 -.08 (- 1.4) (-3.6) (.9) 3. 1966.06-1979.06 -.69 .53 (-.9) (7.4) 4. 1966.06-1983.12 -.11 5. 1970.12-1979.06 6. 1970.72-1983.12 Notes: The mation rate measured See for as year, as .61 (.05) (3.4) - 1.7 (-2.4) .59 (10.4) - .oo (- .OO) (1.3) subperiods of time t. 29 for details reported mainly or by December) here current the survey yearly inflation rate on way growth the the are and of is mode, measured rates ECONOMIC regression Pt-l, again are the .322 1.6/1.0 .79 .522 1.8/.4 .82 .506 1.9/.5 .96 .390 2.3/ -.3 .93 .435 1.8/.2 .44 .44 (6.4 equation inflation as of .29 (6.1) .07 actual 1.7/.8 .32 .17 the past .285 (4.9) (11.7) of time t (June . P,-,, the lagged footnote .07 -2.5 expectations A6 DW/p (2.7) (1.a .oo .17 .24 .16 .04 SER .09 (2.1) (.5) (8.0) ii2 (1.99) (-3.9) various inflationary known previous 32 estimates of .Ol Mt (2.6) -.14 61) .52 (-1.3) pt-2 and lagged time (2) yearly t two years computed. REVIEW, MARCH/APRIL from money 1985 Table growth III. rates. inflation ago, and rate &, This regression Pt is the measured the actual explains actual as yearly of yearly time money the for- inflation t in the growth estimated coefficient on the first known value of the inflation rate in the equation also rises dramatically as one moves from the low-inflation period regressions to the high-inflation period regressions (compare the coefficient on Pt in rows 1 through 6 in Table IV). This probably suggests a relatively fast adjustment of inflationary expectations to current realized rates of inflation.aO Another way to examine the sensitivity of inflationary expectations to money growth is to estimate the time path of the coefficient on the money growth variable in the expectations formation equation. One simple way to do so is to estimate and plot the stabilogram for this coefficient. The stabilogram for any coefficient in a regression equation is simply a plot of the estimated coefficients and confidence intervals for various subperiods in a given sample. By choosing sufficiently short intervals and estimating the stabilogram, one can detect any change in the time path of the relevant coefficient by examining the time path of the stabilogram.al Figure 3 presents this stabilogram for the coefficient on the money growth variable in the expectation formation equation (2) from Table III. This plot clearly suggests that inflationary expectations proxied by the Livingston survey measure have become more sensitive to money growth over time. Figure 3 STABILOGRAM GROWTH COEFFICIENT EXPECTATION 62106 67106 et/12 56/12 61/08 es/12 The stabilogram in the A SUMMARY, MAIN CONCLUSIONS, AND SOME POLICY IMPLICATIONS where This paper has investigated the issue of whether a significant liquidity effect of money on interest rate exists. The recent empirical evidence on this issue has been mixed. One main problem with the current empirical work on this issue is the use of an inappropriate estimation procedure. The current empirical work usually investigates the existence of the liquidity effect by using OLS to estimate nominal interest rate regressions in which money growth appears as a right-hand side regressor. This procedure implicitly assumes that changes in money growth are exogenously determined and, in particular, are not contemporaneously correlated with the f (constant, coefficient equation is con- equation. Ft, 6t.1, ;t-2, 016, D2fi. D4F;1, D51;1, DSi-?, D7&) is Dl times the money growth variable fit, DZM t$, and so on. is D2 times the money variables defined Dl growth formulation from the following Dlfi 79/12 10112 mm 74112 79m6 83112 66/08 mm on the money expectation PE12= Dl through growth D7 variable are the dummy below: is one in 1952/W1956/12 and zero otherwise, D2 is one in 1957/06-1961/06 and zero otherwise, D3 is one in 1961 /I 2-1965/l 2 and zero otherwise, D4 is one in 1966/06-1970/06 and zero otherwise, D5 is one in 1970/12-1974/12 and zero otherwise, D6 is one in 1975/06-1979/06 D7 is one in 1979/l The coefficients and zero otherwise, 2-1983/l 2 and zero otherwise. appearing on these dummy variables can be taken as the point estimates of the coefficient on money growth subperiods; necting these point estimates. of the estimated then 30 Mullineaux (1980) reports similar evidence for the short-term inflationary expectations. Using the varying parameter estimation technique, Mullineaux estimates the time path of the coefficients on the first known values of past inflation rate and money growth. He finds that the various used indicated coefficients Ill DATA: 1952/06-1983/12 DSb, rise in the size of these 2, TABLE SEMIANNUAL IV. is a steady IN THE FORMATION EQUATION structed there ON THE MONEY to AB is simply coefficients construct as vertical for by con- The standard errors on these dummies are the lines. variable formed confidence The upper intervals and lower limits of this confidence band are from the follow- ing relation: Coefficient mated Standard [Estimated t (2.0) (Esti- Error of the Coefficient)] over time (see Figure 1, p. 155). a1 See Ashley (1984) for further details. FEDERAL RESERVE BANK OF RICHMOND 33 error term in these regressions. This is a question- able assumption to make Federal has conducted Reserve in view of the way its monetary policy over the period 1952-1983. term monetary policy stance has been constrained the Federal financial Reserve’s In particular, concern environment to promote of exogenous growth is likely to be correlated in nominal interest shocks. of this nonzero ordinary least squares tistical estimates are biased. could generate an bias about the existence effect. The approach and the magnitude taken omy and to estimate, there quidity the determined reported term that the on sta- inference is to specify a model of the econ- the instrumental variable implied interest nominal in which money growth endogenously First, using procedure, rate equation results Supply is treated variable. The here imply the following did exist a statistically monetary as an empirical conclusions. significant li- policy is the time pattern higher money growth Keynesian lower nominal over the subperiod in the mid-Y% cant when subperiod ending beginning or the early ‘7Os, but it is not signifi- the same equation beginning is estimated in the mid-% over the or the ’70s but in 1979 or 1983. Livingston sentative survey participants of the behavior the economy, of inflationary An empirical is considered of other economic this vanishing the ’70s is probably siveness is that if the behavior of the liquidity the result analysis as repreagents in effect in of increased expectations of the respon- to higher money of the factors deter- however, celeration interest 34 ECONOMIC their REVIEW, While Reserve view may nominal immediately rates is shorter policy purposes. following lived and less exploitable by increasing It now appears and supply. to do so has declined, responsiveness Finally, influence pectations of inflationary be pointed its monetary the growth that its due to the inexpectations to out that the public’s Reserve policy has formulates considerable on the responsiveness of inflationary exto higher money growth. The upward drift in the growth observed the rate of money contributed during that States inflation, which occurred to the higher More period. United success in curbing monetary mainly of the way the Federal the ’70s probably however, for growth. it should executes of and real interest rates at least for six months money an ac- In the ’50s and the ‘6Os, the Federal rate of the money creased interest rate, this lowering Reserve could induce falling nominal has had considerable and public confidence policy as a means of controlling in inflation recently, in inflationary expectations may have risen as a result. If so, we may observe yet another change in the response of inflationary expectations to higher money growth. with caution. in forming an The policy that the Keynesian in the money growth more growth imply rates may still decline is already to money following rate. rates and hold them there now have to be modified. mining the Livingston survey inflation measure implies that these economic agents have over time paid attention The observe (at least for six to nine months) by The results the money growth rate. accelerating rate The second conclusion growth. in the ’50s and ending rates growth down interest perception is estimated of in the short run cient on the money growth variable interest rate regression is negative, this equation real interest in the money rates. initially could bring higher when and one would of this view is that the Federal average inflation rate was very low. This liquidity effect, however, has now almost vanished. The coeffi- significant implica- of the effects of interest implication ability in the nominal large, and sta- on nominal view is that acceleration effect in the ’50s and the early ’60s when the tistically here have important mechanism of the liquidity in this paper presented of the transmission here, simple IS-LM-Aggregate estimation The results effect in money growth. issue in discussion to a Such incorrect with a given acceleration a stable of the parameter variable This factor tends of the liquidity An important The potential growth associated inflation. the magnitude theory and policy. money implies of long-term to reduce directly tions for monetary with the error correlation expectations by As a result, rate regressions. presence the money the shorter and has had to be adapted variety the under way, the empirical sample period ending MARCH/APRIL 1985 and nominal interest rates To the extent such a change results for the in the year 1983 must be viewed i References Ashley, Richard. “A Simple Test For Regression Parameter Instability.” Economic Inquiry (April 1984), pp. 253-67. Holder+ K., and D. A. Peel. “The Relationship Between Prices and Money Supply in Latin America.” Review of Economics and Statistics (August 1979), pp. 446-50. Axilrod, Stephen H. “II. S. Monetary Policy in Recent Years: An Overview.” Federal Reserve Bulletin (January 1985), pp. 14-24. .- Jacobs, R. L., and Robert A. Jones. “Price Expectations in the United States. 1947-1975.” American Economic Review (June 1980), pp. 269-77. Cagan, P. D. The Channels of Monetary Effects on Interest Rates. New York: National Bureau of Economic Research, 1972. Levi, Maurice, and John Makin. “Anticipated Inflation and Interest Rates.” American Economic Review (December 1978)) pp. 801-12. , and A. Gandolfi. “The Lag in Monetary Policy as Implied by the Time Pattern of Monetary Effects on Interest Rates.” American Economic Review (May 1969)) pp. 277-84. Lombra, Raymond E., and Raymond G. 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Karamouzis. “Monetary Polmy and Real Interest Rates; New Evidence From the Money Stock Announcements.” Federal Reserve Bank of Cleveland, Working Paper No. 6, 1984. I Gibson, W. E. “The Lag in the Effect of Monetary Policy on Income and Interest Rates.” Quarterly Journal of Economics (May 1970), pp. 288-300. ii Gordon, Robert J. “New Evidence that Fully Anticipated Monetary Changes Influence Real Output After All.” NBER Working Paper No. 361, June 1979, pp. l-38. Poole, William. “Federal Reserve Operating Procedures: A Survey and Evaluation of the Historical Record Since October 1979.” Journal of Money, Credit and Banking (November 1982, Part 2)) pp. 575-96. “Anticipated Inflation and the Sargent, Thomas J. Nominal Rate of Interest.” The Quarterly Journal of Economics (May 1972), pp. 212-25. Urich, Thomas J. “The Information Content of Weekly Money Supply Announcements.” Journal of Monetary Economics (July 1982)) pp. 73-82. Gramlich, Edward M. “Models of Inflation Expectations Formation: A Comparison of Household and Economist Forecasts.” Journal of Money, Credit and Banking (May 1983), pp. 165-73. , and Paul Wachtel. “The Structure of Expectations of the Weekly Money Supply Announcement.” Journal of Monetaru Economics (March 1984), pp. 183-94. ’ Grossman, J. “The Rationality of Money Supply Expectations and the Short-Run Response of Interest Rates to Monetary Surprises.” Journal of Money, Credit and Banking (November 1981), pp. 409-24. FEDERAL RESERVE Wilcox. James A. “Whv Real Rates Were So Low in the 1970’s.” American Economic Review (March 1983), pp. 44-53. BANK OF RICHMOND 35
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