Friday, September 20, 2013

Roger Farmer on the Natural Rate Hypothesis and the Phillips Curve

Following yesterday's post about the Phillips Curve, Roger Farmer kindly emailed me and drew my attention to some of his related work.

One of his articles appeared recently in the Bank of England's Quarterly Bulletin - see here. It's titled, "The Natural Rate Hypothesis: An Idea Past its Sell-By Date". The "quick summary" is as follows:
  • "Central banks throughout the world predict inflation with New Keynesian models where, after a shock, the unemployment rate returns to its so-called ‘natural rate’. That assumption is called the Natural Rate Hypothesis (NRH).
  • This paper reviews a body of work, published over the past decade, in which I argue that the NRH does not hold in the data and provide an alternative paradigm that explains why it does not hold.
  • I replace the NRH with the assumption that the animal spirits of investors are a fundamental of the economy that can be modelled by a ‘belief function’. I show how to operationalise that idea by constructing an empirical model that outperforms the New Keynesian Phillips Curve."
On p.246 of his article, Roger has a very nice illustrated summary of the estimation of the first Phillips Curve.

To induce you to read Roger's paper, let me quote from its concluding section: 
"At the outset of this article I offered not just to provide a critique of macroeconomic theory: but also to provide a constructive alternative with which to rebuild it. That alternative is based on a return to two central ideas of Keynes’ General Theory. First, that high involuntary unemployment can persist as an equilibrium of a market economy and second, that the equilibrium that prevails is selected by the animal spirits of market participants.
Economists and central bankers can no longer afford to continue using the NRH. It is an idea that is past its sell-by date. I have offered a replacement that recovers Keynes’ two central ideas and I have shown that this new paradigm outperforms the New Keynesian model when confronted with data.
By modelling the labour market with a search model where factor markets are incomplete, I have shown how to construct a logical microeconomic foundation to Keynesian economics. And by modelling beliefs as a new fundamental with the same methodological status as preferences, I have shown how to construct a complete DSGE model that provides a coherent
explanation of macroeconomic data."
Definitely a must-read article!

© 2013, David E. Giles

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