Thursday, March 01, 2007

Typology of Anti-NAIRUvians

The NAIRU Theory or Natural Rate Theory of Unemployment essentially consists of two propositions about the Phillips curve (the relationship between inflation and unemployment as nominal aggregate demand* varies):
  1. The Phillips curve is downward-sloping in the short run.
  2. The Phillips curve is vertical (or possibly upward-sloping) in the long run.
Accordingly, there are essentially four ways to challenge the theory:
  1. Argue that the Phillips curve is vertical in the short run, as in many real business cycle models.
  2. Argue that the Phillips curve is horizontal in the short run, as in my suggestion here
  3. Argue that the Phillips curve is downward-sloping in the long run, as in Tobin’s “greasing the wheels” theory.
  4. Argue that the Phillips curve has the required NAIRU properties in theory but that it is so unstable and unpredictable as to render the concept useless in practice. (This seems to be roughly the argument made by Bob Hall recently.)
(I have ignored the possibility of an upward-sloping short-run Phillips curve because it just seems too silly to me. Any upward-sloping short-run Phillips curve that anyone is likely to advocate will either be approximately vertical or approximately horizontal.)

It is clear that these different challenges to the NAIRU theory have very different policy implications. For example, if you believe challenge #1, you might argue for aggressive policy tightening in response to any increase in the inflation rate above your preferred target, whereas if you believe challenge #3, you might argue for no tightening at all. And while challenge #4 is perhaps the most viable, it also raises the question of what alternative one might use to guide policy, and if there is no viable alternative, one has to wonder how Fed policy has managed to be so successful over the past 20 years. Anyhow, it is incumbent upon those who challenge the NAIRU theory to identify the specific nature of their challenge.

* I use the word “nominal” to accommodate those who don’t believe in the concept of aggregate demand. If you don’t like the phrase “aggregate demand,” how about “velocity-adjusted nominal money supply.”

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Blogger Gabriel Mihalache said...

Knzn: You should believe in God!
Gabriel: Why?
Knzn: If you don't believe in God then you should prove he doesn't exist.
Gabriel: WTF?

Now, just replace "God" with "NAIRU".

It's not up to me to propose a better model of the economy, because I disagree with the usefulness (or sense) of the decomposition of unemployment into NAIRU and fluctuation.

Now, regarding the issue... what I see missing from your post is a discussion of expected vs. unexpected. Lucas' supply curve, the one from the islands, seems the most theoretically sound case for a downward sloping P.C. -- but there, and in real life I would argue, fragile empirical regularities are not policy menus.

The Fed's success comes from it not screwing up. Also, following a "degenerate" Taylor rule, with a 0 or near 0 coefficient on the "output gap" should be more than adequate. The '30s, the '70s... those have been paybacks for bad policy.

The Unholy Trinity of Macroeconomics, {Y*,u*,r*}, seems to me to be a deficient way of looking at things. Prescott showed how the "real", neutral, neo-classical economy can be very volatile (up to 70% of the volatility of post-WW2 US).

We're better off with DSGE models, with indivisible labor, taxes and 2-3 sources of fluctuations (productivity, monetary, taxes). The Fed's job should be to control inflation by controlling the money supply via the short-term interest rate. Or, better yet, by freezing high-powered money.

(I think I will start calling myself "Anti-NAIRUvian". Sounds mysterious!)

Thu Mar 01, 02:01:00 PM EST  
Blogger knzn said...

Gabriel, even if you follow a degenerate Taylor rule, the optimal parameters of that rule depend on your view of the Phillips curve. I'm not saying you should prove that the NAIRU doesn't exist, only that you should specify which alternative view of the world you hold. (From my reading it sounds like you think that the SRPC is approximately vertical, or at least close enough that there is no practical advantage in assuming a downward slope. Anyhow your view is clearly quite different from what Dean Baker and James Galbraith have in mind when they attack the NAIRU.)

Freezing high-powered money. Oh, my. Sounds like exactly the kind of bad policy for which the 30s were payback.

Thu Mar 01, 02:43:00 PM EST  
Blogger Gabriel Mihalache said...

My view is that of Lucas, a few decades ago. The PC is vertical for expected money shocks, downward sloping for unexpected shocks; and that it shouldn't be tought of as a policy space.

That, plus the idea that monetary factors influencing unemployment are far smaller, in "normal times", than productivity-caused fluctuations.

Fri Mar 02, 09:57:00 AM EST  
Blogger Gabriel Mihalache said...

Knzn, I'm sure you're going to love this: Theory Ahead of Language in the Economics of Unemployment -- Richard Rogerson. Maybe you know it already. In which case, it's for the audience. :-)

Fri Mar 02, 03:14:00 PM EST  
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