Business Review
Q3 2002 27
www.phil.frb.org
Milton Friedman has suggested that theFed should endeavor to keep the moneysupply growing at a constant rate, oneconsistent with long-run price stability ora modest level of long-run inflation.
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In 1979, economist John Taylorsuggested a different possibility.
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Taylorpointed out that the temporary tradeoff between inflation and unemploymentwas consistent with a permanenttradeoff between the
variability
of inflation and the
variability
of outputover time. At some point, policymakersface a choice between lowering thevariability of output at the cost of morevariability in the inflation rate orlowering the variability of the inflationrate at the cost of more variability inoutput. In his article, Taylor estimatedthe tradeoff between variability ininflation and output for the U.S.economy.
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This “Taylor curve” displaysone set of options available topolicymakers when monetary policyactions have only temporary effects onthe unemployment rate.In this article, I will explainhow policymakers can exploit atemporary tradeoff between theunemployment and inflation rates toconsistently achieve particular inflationand output variability combinations onthe Taylor curve.
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Then I will discusswhat lessons about the conduct of monetary policy can be drawn from theTaylor curve. Taylor has argued that thevery shape of the curve reveals thegeneral nature of the monetary policyrule that macroeconomists shouldrecommend to policymakers. I suggestthat macroeconomists should becautious about recommending anyparticular policy rule too strongly untilmore is known about the effects thatdifferent combinations of inflation andoutput variability (on the Taylor curve)have on a typical household’s standardof living.
A PRIMER ON THE THEORY OFTHE NATURAL RATE OFUNEMPLOYMENT
The proposition that the policychoices suggested by the Phillips curvecannot be sustained is a key implicationof the
theory of the natural rate of unem- ployment.
Since the natural rate theory isTaylor’s point of departure in his searchfor a sustainable tradeoff between infla-tion and output, it’s best to begin with abrief description of this theory and itsimplications for the Phillips curve.The theory of the natural rateof unemployment centers on thedeterminants of the unemployment rate.The theory makes a distinction betweenthe fundamental determinants of theunemployment rate and nonfunda-mental factors. Fundamental determi-nants are factors that change slowly overtime, such as demographics, technology,laws and regulations, and social mores.These fundamental factors determinethe
natural rate of unemployment
.However, because of nonfundamentalfactors, the actual unemployment ratecan deviate from the natural rate. Thetheory links these deviations to eventsthat cause the actual inflation rate, atany given date, to diverge from theinflation rate expected for that date inearlier periods.The reasoning underlying thislink goes as follows.
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In modernindustrial economies, it’s common forworkers to enter into employmentcontracts in which they agree to supplyas many hours of work as demanded bytheir employers (within reasonablelimits) for an agreed-upon wage rate orsalary. This contractually fixed wagerate or salary reflects, in part, whatworkers and employers expect theinflation rate to be over the term of thecontract. If the inflation rate turns out tobe as expected, employers demand (andworkers supply) the normal level of workhours, and the overall unemploymentrate is close to the natural rate. If theinflation rate turns out to be higher thanexpected, employers buy additionalwork hours because the price at whichthey can sell their products is higherthan expected but the wage they mustpay for additional hours of work remainscontractually fixed. In this case theutilization of labor rises, and theunemployment rate tends to fall belowthe natural rate. Conversely, if theinflation rate turns out to be lower thanexpected, firms lay some workers off because the price at which firms can selltheir products is now lower thanexpected but the wage they must paytheir workers remains contractuallyfixed.
In this case, the utilization of laborfalls, and the unemployment rate tends
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Taylor couches his arguments in terms of variability of output rather than unemploy-ment but this difference is not importantbecause the two are closely related.Macroeconomists often use a rule of thumb totranslate variability in output to variability inthe unemployment rate. The rule of thumb isthat a 1-percentage-point reduction in theunemployment rate goes hand-in-hand with a3-percentage-point increase in output. Thisrule of thumb, which appeared in a 1971article by Arthur Okun, is referred to asOkun’s Law. For the sake of comparison withthe Phillips curve, later in the article I’llcouch Taylor’s arguments in terms of thevariability of the unemployment rate insteadof output.
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Economists refer to this tradeoff as a “policymenu.”
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Friedman stated his views in his 1967presidential address to the AmericanEconomic Association. The text of his addressappears in his 1968 article.
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John Taylor is professor of economics atStanford University and a renowned scholaron issues concerning monetary policy.Professor Taylor has served as a member of thePresident’s Council of Economic Advisers andis currently serving as Undersecretary forInternational Affairs at the U.S. Departmentof Treasury.
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There are two variants of the natural ratetheory. The text describes the variantformulated, in part, by Taylor, which forms thebasis for Taylor’s subsequent work. RobertLucas Jr. developed the other variant, whichfocuses on informational frictions rather thanemployment contracts. Both variants appearto be consistent with the evidence.
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