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.

On Zero Correlation and Statistical Independence

I put the following material together yesterday in response to a request from one of our grad. students. I thought it might be helpful to some readers of the blog.