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THE EVOLUTION AND POLICY IMPLICATIONS

OF PHILLIPS CURVE ANALYSIS
Thomas M. Humphrey

At the core of modern macroeconomics is some steps that led to this change. Accordingly, the para-
version or another of the famous Phillips curve rela- graphs below sketch the evolution of Phillips curve
tionship between inflation and unemployment. The analysis, emphasizing in particular the theoretical
Phillips curve, both in itspriginal and more recently innovations incorporated into that analysis at each
reformulated expectations-augmented versions, has stage and the policy implications of each innovation.
two main uses. In theoretical models of inflation, it
provides the so-called “missing equation” that ex-
plains how changes in nominal income divide them- I.
selves into price and quantity components. On the
EARLY VERSIONS OF THE PHILLIPS CURVE
policy front, it specifies conditions contributing to
the effectiveness (or lack thereof) of expansionary The idea of an inflation-unemployment trade-off is
and disinflationary policies. For example, in its hardly new. It was a key component of the monetary
expectations-augmented form, it predicts that the doctrines of David Hume (1752) and Henry Thorn-
power of expansionary measures to stimulate real ton (1802). It was identified statistically by Irving
activity depends critically upon how price anticipa- Fisher in 1926, although he viewed causation as
tions are formed. Similarly, it predicts that disinfla- running from inflation to unemployment rather than
tionary policy will either work slowly (and painfully) vice versa. It was stated in the form of an econo-
or swiftly (and painlessly) depending upon the speed metric equation by Jan Tinbergen in 1936 and again
of adjustment of price expectations. In fact, few by Lawrence Klein and Arthur Goldberger in 1955.
macro policy questions are discussed without at least Finally, it was graphed on a scatterplot chart by A. J.
some reference to an analytical framework that might Brown in 1955 and presented in the form of a dia-
be described in terms of some version of the Phillips grammatic curve by Paul Sultan in 1957. Despite
curve. these early efforts, however, it was not until 1958
As might be expected from such a widely used tool, that modern Phillips curve analysis can be said to
,Phillips curve analysis has hardly stood still since its have begun. That year saw the publication of Pro-
beginnings in 1958. Rather it has evolved under the fessor A. W. Phillips’ famous article in which he
pressure of events and the progress of economic fitted a statistical equation w=f (U) to annual data
theorizing, incorporating at each stage such new on percentage rates of change of money wages (w)
elements as the natural rate hypothesis, the adaptive- and the unemployment rate (U) in the United King-
expectations mechanism, and most recently, the ra- dom for the period 1861-1913. The result, shown
tional expectations hypothesis. Each new element in a chart like Figure 1 with wage inflation measured
expanded its expIanatory power. Each radically verticaIIy and unempIoyment horizontally, was a
altered its policy implications. As a result, whereas smooth, downward-sloping convex curve that cut the
the Phillips curve was once seen as offering a stable horizontal axis at a positive level of unemployment.
enduring trade-off for the policymakers to exploit, The curve itself was given a straightforward inter-
it is now widely viewed as offering no trade-off at all. pretation : it showed the response of wages to the
In short, the original Phillips curve notion of the excess demand for labor as proxied by the inverse of
potency of activist fine tuning has given way to the the unemployment rate. Low unemployment spelled
revised Phillips curve notion of policy ineffectiveness. high excess demand and thus upward pressure on
The purpose of this articIe is to trace the sequence of wages. The greater this excess Iabor demand the

FEDERAL RESERVE BANK OF RICHMOND 3

e. variety of inflation theories. At higher unemploy. fitted the United Kingdom data for the post-World ment rates excess supply exists to bid down War II period 1948-1957 equally well or even better. Accordingly. One was the remarkable temporal stability of the relationship. The Phillips curve could accommodate increasing unemployment as indicated by the negative both views. however. Finally. exist even when the market was in equilibrium. excess Thus a demand-pull theorist could argue that excess- labor supply) that put deflationary pressure on demand-induced inflation stems from excessively wages. The curve’s convex shape shows that increasing excess demand for labor runs into Such apparent stability in a two-variable relationship diminishing marginal returns in reducing un. wage inflation would union monopoly power and real shocks operating on rise with decreasing unemployment and fall with labor supply. high unemploy. Frictional (and Structural) excess demand (and thus wage inflation rates) to. It was en- tirely neutral. Thus successive uniform de empirical economics and served to excite interest in creases in unemployment (horizontal gray the curve. Unemployment Rate at achieve them. Now excess demand can of course be generated either by shifts in demand or shifts in faster the rise in wages. It is important to understand why this was so. 4 ECONOMIC REVIEW. ment spelled negative excess demand (i. when excess labor demand was zero and wages were stable. arrows) require progressively larger increases in excess demand and hence wage inflation A second factor contributing to the success of the rates (vertical black arrows) as we go from Phillips curve was its ability to accommodate a wide point a to b to c to d along the curve. a stability re- At unemployment rate Uf the labor market is in equilibrium and wages are stable.. this is also the point to which the economy w Wage Inflation Rate 1%) returns if the authorities ceased to maintain dis- equilibrium in the labor market by pegging the excess Phillips Curve Trade-off demand for labor. At least three factors probably contributed to the attractive- ness of the Phillips curve. this frictional unemploy- Figure 1 ment was indicated by the point at which the Phillips EARLY PHILLIPS CURVE curve crosses the horizontal axis. owing to unavoidable the Phillips curve as offering insights into the nature frictions in the operation of the labor market. wages. which in turn varied push theorist could claim that it emanates from trade- inversely with unemployment. about the causes of that phenomenon. that is. Moreover. Which Overall Excess Demand for Labor is Zero and Wages are Popularity of the Phillips Paradigm therefore Stable Once equipped with the foregoing theoretical foun- dations. MARCH/APRIL 1985 . According to Phillips. it of the inflationary process even while disagreeing on followed that some frictional unemployment would the causes of and appropriate remedies for inflation. it followed that the curve must be convex-this convexity showing that successive uniform decrements in unemployment would require progressively larger increments in . supply regardless of the causes of those shifts. the Phillips curve gained swift acceptance Unemployment among economists and policymakers alike. since increases in excess demand would likely run into diminishing marginal Inflation and Unemployment returns in reducing unemployment. At vealed by Phillips’ own finding that the same curve lower unemployment rates excess demand estimated for the pre-World War I period 1861-1913 exists to bid up wages. The Phillips curve itself explained inflation as resulting from excess demand that bids up wages and prices. Since the rate of change of wages varied expansionary aggregate demand policies while a cost- directly with excess demand. over such a long period of time is uncommon in employment. Similarly. Economists of rival schools could accept slope of the curve.

(1) P = K C . coefficient and the amount of unemployment associ- provided a ready-made justification for discretionary ated with any given level of excess demand. Using these macroeco- useful to policymakers. Substituting (2) into (I). and productivity variables. the relevant policy trade-offs (rates of exchange cluding normal profit margin and provision for depreci. or From Wage-Change Relation to frontier. early 1960s. intervention and activist fine tuning. Finally. This transformation was could not. Assuming productivity growth q is zero and the rate of For example. the initial Phillips curve depicted a Determined by the structure of labor and product relation between unemployment and wage inflation. it was therefore necessary to nomic demand-management policies the authorities transform it from a wage-change relationship to a could put the economy anywhere on the curve. the authorities could point to the demand. policies aimed at lowering the price-response nations from which the authorities could choose. explained in early Phillips curve analysis. The rate at which one objective (3) P = w . however. As ation) applied to unit labor costs C. all coordinates of inflation and unemployment rates gets in terms of rates of change of prices rather than the authorities could achieve via implementation of wages. markets. They price-change relationship.’ The result of this transforma. taking logarithms of both sides simultaneously achievable. it would be impossible for mone- rates of growth of wages and productivity (the latter tary and fiscal policy alone to reach inflation- assumed zero here). wage. usually specify inflation tar. operate to the left of it. They either arbitrarily low unemployment or price stability could also use it to measure the effect of policies- but not both. unemployment combinations in the region to the left tion was the price-change Phillips relation of the curve. Accordingly. to make the Phillips curve more monetary and fiscal policies. As noted above. Phillips curve was viewed as a constraint preventing ing a constant mark-up to unit labor cost and so move them from achieving still lower levels of both inflation in step with wages--or. move at a and unemployment. When the Q? goals of full employment and price stability are not (2) C = W/Q. and then differentiating with economy closer to one will necessarily move it further respect to time yields away from the other. (1) P = =GJ> makers because it provided a convincing rationale for where p is the rate of price inflation.q where the lower case letters denote the percentage rates must be given up to obtain a little bit more of the of change of the price. menu of alternative inflation-unemployment combi- i. x(U) is overall their apparent failure to achieve full employment excess demand in labor and hence product markets- with price stability-twin goals that were thought to this excess demand being an inverse function of the be mutually compatible before Phillips’ analysis. distance from origin) and slope of the Phillips curve not to mention the economic advisors who supplied -two features stressed in policy discussions of the the cost-benefit analysis underlying their choices. Note also that the curve. sloped. For this reason too the The foregoing equation specifies the position (or curve must have appealed to some policy authorities. of feasible (attainable) combinations of Price-Change Relation inflation and unemployment rates (see Figure 2). the Phillips curve appealed to policy. Policymakers had but to select the best (or least undesirable) Trade-Offs and Attainable Combinations combination on the menu and then use their policy instruments to achieve it. unemployment rate-and a is a price-reaction coeffi- When criticized for failing to achieve both goals cient expressing the response of inflation to excess simultaneously. then attempts to move the of the resultinn exoression. the position of the curve defines the set of Policymakers. The slope of the curve was interpreted as showing 1 Let prices P be the product of a fixed markup K (in. Given the structure of labor and rate equal to the differential between the percentage product markets. As seen by the policymakers of that era. between policy goals) available to the authorities. it means that a small reduction in unemploy- FEDERAL RESERVE BANK OF RICHMOND 5 . these Unit labor costs by definition are the ratio of hourly trade-offs arise because of the existence of irrecon- wages W to labor productivity or output per labor hour cilable conflicts among policy objectives. however. when the Phillips curve is steeply wage change w is an inverse function of the unemploy- ment rate yields equation (1) of the text. other is measured by the slope of the Phillips curve. the curve’s position fixes the inner boundary. by offering a undertaken to obtain a more favorable Phillips curve. more precisely.e. The achieved by assuming that prices are set by apply.. From this equation the authorities could Phillips curve as showing that such an outcome was determine how much unemployment would be asso- impossible and that the best one could hope for was ciated with !ny given target rate of inflation.

the lower tively flat portions of the curve. the authorities’ task was to select the particular ATTAINABLE COMBINATIONS inflation-unemployment mix resulting in the smallest social cost (see Figure 3). Indicates THE MENU OF CHOICES Trade-off p Price Inflation Rate Phillips Curve Constraint The position or location of the Phillips curve defines the frontier or set of Optimum Feasible attainable inflation-unemployment combi. inflation and unemployment. Combination the authorities can attain all combinations lying upon the frontier itself but none in the shaded region below it. Here the additional social benefit from a unit reduction in The Best Selection on the Phillips Frontier unemployment will just be worth the extra inflation cost of doing so. U The bowed-out curves are social disutility contours. they would p Price I&ffation Rate (96) have to assign relative weights to the twin evils of Phillips Curve / Frontier p=axKl): \ Shows Attainable Inflation-Unemployment . In this way the curve acts as a constraint on demand- management policy choices. The best Knowledge of these trade-offs would enable the combination of inflation and unemploy- authorities to determine the price-stability sacrifice ment that the policymakers can reach. The preceding has described the early view of the Phillips curve as a stable. in rela. enduring trade-off per- mitting the authorities to obtain permanently lower 6 ECONOMIC REVIEW. Combinations Figure 3 THE BEST SELECTION ON Slope A--. Inflation-Unemployment nations. that reflect the relative weights that society (or the policy authority) assigns to the evils of is at the cost of only slight increases in inflation. Each contour shows all the com- binations of inflation and unemployment ment would be purchased at the cost of a large in. To do this. The slopes of these contours unemployment could be obtained fairly cheaply. Put differ- ently. resulting in a given level of social cost or crease in the rate of inflation. is the mix appearing on the lowest attainable social ployment rate. disutility contour. Given the menu. the Phillips curve constraint. considerably lower the social cost. Using monetary and fiscal policies. given necessary to buy any given reduction in the unem. the curve was interpreted as offering a menu Figure 2 of alternative inflation-unemployment combinations TRADE-OFFS AND from which the authorities could choose. harm. rates of unemployment in exchange for permanently higher rates of inflation or vice versa. The closer to the origin. MARCH/APRIL 1985 . The slope of the curve shows the tradeoffs or rates of exchange between the two evils of inflation and unemployment. Conversely.

excess demand would dis- appear and the economy would return to the point at which the Phillips curve crosses the horizontal axis. It was Administration of course understood that if this outcome involved a positive rate of inflation. however. p Price Inflation Rate mum. another administration might deliberately ployment-averse administration will choose a point on the Phillips curve involving more aim for a low pressuse economy because it believed inflation and less unemployment than the that some economic slack was a relatively painless combination selected by an inflation-averse means of eradicating harmful inflation. The cruel dilemma refers FEDERAL RESERVE BANK OF RICHMOND 7 . using monetary and fiscal policy. continuous excess money Social Disutility Contours: growth would be required to maintain it. Then. there was much discussion of ary. Policymakers who Different political administrations may believed that unemployment was more undesirable differ in their evaluations of the social than rising prices would assign a much higher relative harmfulness of inflation relative to that of weight to the former than would policymakers who unemployment.inflation and unemployment in accordance with their views of the comparative harm caused by each. Different Outcomes It was also recognized that policymakers might differ in their assessment of the comparative social 0 cost of inflation vs. would of course prefer combinations to the southwest of the Phillips constraint. Hence. As pointed out before. which determines the position or location of the “Cruel Dilemma” Phillips frontier. this would be impossible given the structure of the econ- Pessimistic Phillips Curve and the omy. unless they were prepared to alter the economy’s the so-called “cruel-dilemma” problem imposed by an structure. Phillips Curve Constraint out curves radiating outward from the origin of Figure 3) allowed by the Phillips curve constraint. The relatively flat in Figure 4. down closer to the figure’s origin (the ideal point of zero inflation and zero un- employment). In the early 196Os. as shown contours (as those contours are interpreted by the policymakers). mix of inflation and unem. Different Preferences. point at which the additional benefit from a further DIFFERENT POLICY CHOICES reduction in unemployment was just worth the extra inflation cost of doing so. unemployment and thus assign different policy weights to each. trading off unemployment Figure 4 for inflation (or vice versa) until they reached the DIFFERENT PREFERENCES. In short. Whereas one political administration contours reflect the views of those attaching might opt for a high pressure economy on the higher relative weight to the evils of infla- grounds that the social benefits of low unemployment tion. those weights to the two evils of inflation and un- with a marked aversion to unemployment would employment. An unem- achieve it. Here would be the opti. the steep contours to those assigning exceeded the harm done by the inflation necessary to higher weight to unemployment. Inflation-Unemployment Choice of an Here the unemployment-inflation combination chosen ’ Unemployment-Averse would be the one that minimized social harm. or least undesirable. For without Unemployment Weighted such monetary stimulus. b I/ ployment. These weights will be re prefer a point higher up on the Phillips curve than fleeted in the slopes of the social disutility would those more anxious to avoid inflation. Both groups administration. unfavorable Phillips curve. they would move along the Phillips curve. the policymakers would be constrained to combinations lying on this bound. Thus in their policy delib erations they will attach different relative judged inflation to be the worse evil. At this point the economy would be on its lowest attainable social disutility contour (the bowed.

tion (point a) or unemployment (point b) but not both. it was argued. down to acceptable levels. twist or shift the Phillips frontier toward the origin Should incomes policies prove unworkable or pro- of the diagram.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). B. were thought to be insufficient to resolve the cruel or by replacing it with an officially mandated rate of dilemma since the most these policies could do was to price increase. these limits define the zone of acceptable or I politically feasible combinations of inflation and Pessimistic or Unfavorable unemployment. and the resulting discontent may I \ Phillips Curve severely aggravate political and social tensions. monetary would lower the rate of inflation associated with any and fiscal policies could move the economy along the given level of unemployment and thus twist down the given curve. the authorities could rely solely on microeconomic tion to excess demand. MARCH/APRIL 19R5 . For example. hibitively expensive in terms of their resource- Of these measures. to achieve combinations of inflation and unemploy. incomes policies would be misallocation and restriction-of-freedom costs. The rationale for i n c o m e s (wage-price) and strucrural (labor marketl Policies to Shift the Phillips Curve policies was to shift the Phillips curve down into the zone of tolerable outcomes. They can achieve acceptable rates of inffa- ment acceptable to society. At best they could hold only one of the variables. the system’s performance will fall short of what was expected of it. Either by decreeing this structural policies to improve the trade-off. that voters are just PESSIMISTIC PHILLIPS CURVE willing to tolerate without removing the party in AND THE “CRUEL DILEMMA” power. If. such policies the pessimistic Phillips curve. Faced with such a pessimistic Phillips curve. were new policies that would being used to boost employment. / Outside the Zone of ety’s demands for reasonable price stability and high Tolerable Outcomes \ employment. It was this concern and frustration over the seem- ing inability of monetary and fiscal policy to resolve the unemployment-inflation dilemma that induced some economists in the early 1960s to urge the adop- tion of incomes (wage-price) and structural (labor- market) policies. The idea was that wage-price controls into the zone of tolerable outcomes. inflation or unemployment. but they could not move the curve itself Phillips curve. then directed at the price-response coefficient linking infla. Monetary and fiscal policies alone coefficient to be zero (as with wage-price freezes). But they A = Maximum Tolerable Rate of Inflation could not hold both simultaneously within the limits B = Maximum Tolerable Rate of Unemployment of toleration. policy- demand-management policies would find it impossible makers are confronted with a cruel choice. or simply by persuading sellers to enable the economy to occupy alternative positions on moderate their wage and price demands. But if both limits are exceeded and the curve lies outside the region of satisfactory outcomes. Lies position anywhere within this zone will satisfy soci. What was would hold inflation down while excess demand was needed. As shown in p Price Inflation Rate Figure 5. That is. 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. Likewise. By en- 8 ECONOMIC REVIEW. A Phillips curve that occupies a Phillips Curve. A. suppose there is some Figure 5 maximum rate of inflation. policymakers armed only with traditional Given the unfavorable Phillips curve. suppose there is some maximum tolerable rate of unemployment. then the policymakers would indeed be confronted with a painful dilemma. as some analysts alleged.

unemployment subsidies. w=f (U) . But if mand variable. the differential between the rates of change of nominal wages and i \ Macro Wage expected future prices. then wages would inflate at the The first was the respecification of the excess de- rate w* both locally and nationally. it should have been stated in terms i of Local Wage 1 Inflation Rates WA and WB of expected real wage changes. job information and labor mobility costs. It is natural in the sense (1) that inflation rate associated with any given level of aggregate unemployment. and the like) and as such is not susceptible to manipulation by aggregate demand policies. Since neoclassical economic theory teaches that real rather I al Phillips Curve: H LoCThe Same for than nominal wages adjust to clear labor markets. w-pe=f(U). tax laws. MARCH/APRIL 1955 . UN-U. Micromarkets A and B however. is independent of the steady-state inflation rate. x(U). In short. Figure 6 Coinciding with this perception was the belated EFFECTS OF UNEMPLOYMENT recognition that the original Phillips curve involved a DISPERSION misspecification that could only be corrected by the incorporation of a price expectations variable in the w Wage Inflation Rate trade-off. Three innovations ushered in this change. The average of these ment.s that the Phillips curve should R WA have been stated in terms of real wage changes. Recognition of this fact No-Dispersion Case led to the development of the expectations-augmented Phillips curve described below. i. U THE EXPECTATIONS-AUGMENTED PHILLIPS CURVE AND THE ADAPTIVE-EXPECTATIONS MECHANISM The original Phillips curve equation gave way to If aggregate unemployment at rate U” were the expectations-augmented version in the early evenly distributed across individual labor markets such that the same rate prevailed 1970s. III. everywhere. the Inflation Rate: original Phillips curve required a price expectations Dispersion Case term to render it correct. inflationary expectations had become too prominent to ignore and many analysts were perceiving them as the dominant cause of observed shifts in the Phillips curve. excess distributed such that rate UA exists in market A and UB in market B. it follow. rate of unemployment itself was defined as the rate ment rate U” is wo which is higher than inflation rate w* of the no-dispersion case. and (3) that it is determined by real structural forces (market frictions and imperfections. Unem- it represents normal full-employment equilibrium in ployment dispersion shifts the aggregate the labor and hence commodity markets. The original Phillips curve has expressed in terms of nominal wage changes. then wages demand was redefined as the discrepancy or gap will inflate at rate WA in the former market between the natural and actual rates of unemploy- and wB in the latter. Originally defined as an inverse aggregate unemployment U” is unequally function of the unemployment rate. I Better still (since wage bargains are made with an Line Showing Weighted / Average eye to the future). 10 ECONOMIC REVIEW.. The natural (or full employment) local inflation rates at aggregate unemploy. the higher the aggregate nor decelerating.e. (2) that it Phillips curve rightward. that prevails in steady-state equilibrium when expec- tations are fully realized and incorporated into all Conclusion: The greater the dispersion of wages and prices and inflation is neither accelerating unemployment.

According to this mechanism.. This expectations stant rate of inflation eventually will be fully antici- variable entered the equation with a coefficient of pated. ones in steady-state equilibrium. cating that when expectations are formulated adap- cient also implies the complete absence of a trade-off tively via the error-learning scheme. the expectations-augmented Phillips The third innovation was the incorporation of an curve. pated. inflation and that vanish once expectations (and the ing. i. The unit expectations coefficient implies (5) p” = &P--i the absence of money illusion. Analysts also demonstrated that equation 4 is (3) p = a(UN-U)+p” equivalent to the proposition that expected inflation where excess demand is now written as the gap is a geometrically declining weighted average of all between the natural and actual unemployment rates past rates of inflation with the weights summing to and pe is the price expectations variable representing one. that changing price expectations expected inflation. points.. expecta. sur- ( 4 ) + = b(p-pe) prise inflation.. indi- As will be shown later. Both versions of the adaptive-expectations Note also that the expectations variable is the sole mechanism (i. rates of inflation.e. the subscript i denotes past time ing power of the prices they pay and receive (or. the difference between actual and expected price transitory phenomena that stem from unexpected inflation). Such revision will continue until the expec- sulting in the expectations-augmented equation tational error is eliminated. that they wish to maintain their prices rates of inflation. there exists no permanent trade-off tions are adjusted (adapted) by some fraction of the between unemployment and inflation since real eco- forecast error that occurs when inflation turns out nomic variables tend to be independent of nominal to be different than expected. an adjustment fraction of s. where the dot over the price expectations variable by raising product prices relative to nominal wages indicates the rate of change (time derivative) of that and thus lowering real wages. But such trade-offs are inherently (i. To be sure. may. For example. All other shift vari. mechanism as tions are completely incorporated in actual price changes. and the error-learning mechanism-formed the expectations-generating mechanism into Phillips basis of the celebrated natural rate and accelerationist curve analysis to explain how the price expectations hypotheses that radically altered economists’ and variable itself was determined. were the predominant cause of observed shifts in the Phillips curve. p-p” is the expectations or forecast error temporarily. or 3 percentage price anticipations into Phillips curve analysis re. it implies that where S indicates the operation of summing the past people are concerned with the expected real purchas. when infla- inflation are 10 percent and 4 percent. wages and prices embodying them) fully adjust to tion 4 says that if the actual and expected rates of inflationary experience.e. equa. rate hypothesis. and vi denotes the weights attached to past alternatively. and excess demand. tionary surprises disappear and expectations are i. the unit expectations coeffi. as can be seen by writing the error-learning unity. equation’s right-hand side becomes simply p. in the early 197Os. respectively. any constant between inflation and unemployment in long-run rate of inflation will indeed eventually be fully antici- equilibrium when expectations are fully realized.. Generally a simple policymakers’ views of the Phillips curve in the late adaptive-expectations or error-learning mechanism 1960s and early 1970s. The second innovation was the introduction of an amount equal to half the error. equations 4 and 5) were combined shift variable in the equation. The Natural Rate Hypothesis Expectations-Generating Mechanism These three innovations-the redefined excess de- mand variable. According to the natural was used. In the long run. trade- offs may exist in the short run. the ing) and so take anticipated inflation into account.e. Assum. periods.e. reflecting the view. for example. In symbols. with the expectations-augmented Phillips equation to ables have been omitted. With a stable inflation rate p relative to the prices they expect others to be charg. and b is the adjustment fraction. This unit sum of weights ensures that any con- the anticipated rate ofg inflation. unemployment FEDERAL RESERVE BANK OF RICHMOND 11 . reflecting the assumption that price expecta. if unperceived by wage earners. prevalent explain the mutual interaction of actual inflation. the expectational error is 6 percent-then the realized such that wages reestablish their preexist- expected rate of inflation will be revised upward by ing levels relative to product prices. unchanging over time and a unit sum of weights. stimulate employment variable.

The economy tempts to exploit them will only succeed in raising travels the path ASIDE to the new steady state equilibrium. That equa. only Phillips Curves surprise price increases could induce deviations of A / Long-run Vertical unemployment from its natural rate. when rearranged to read p-p”=a(Ux-U). when p-pe equals zero). Movements to curves each corresponding to a different given expected rate of inflation. also thus reducing the efficiency of the price system as a coordinating and allocating mechanism. -4 equation 3 asserts that inflation-unemployment trade- offs cannot exist when inflation is fully anticipated. the long-run Phillips curve may become posi- tively sloped in its upper ranges as higher inflation leads to greater inflation variability (volatility. higher rate of inflation. In short. inflation is higher than it was originally. states that the trade-off is between unexpected infla. when tivity and by introducing noise into market price signals. MARCH/APRIL 1985 . SR. The equation also says that the trade-off disappears when inflation “I” I Phillips Curve is fully anticipated (i. Moreover. H i g h e r a n d hence more variable and erratic infla- tion can raise the equilibrium level of The Accelerationist Hypothesis unemployment by generating increased 0 u U uncertainty that inhibits business ac. implying that the long-run Phillips figure 7 curve is a vertical line at the natural rate of unem- THE NATURAL RATE ployment. where unemploy- the permanent rate of inflation without accomplish- ment is at its preexisting natural rate but ing a lasting reduction in the unemployment rate. point E. p-p”) and unemployment. a 1 Sl \’ \ I result guaranteed for any steady rate of inflation by the error-learning mechanism’s unit sum of weights.. HYPOTHESIS AND ADJUSTMENT Equation 3 embodies these conclusions. The expectations-augmented Phillips curve. Attempts the left along a short-run Phillips curve only provoke to lower unemployment from the natural expectational wage/price adjustments that shift the rate UN to U1 by raising inflation to 3 per- curve to the right and restore unemployment to its cent along the short-run tradeoff curve So will only induce shifts in the short-run curve natural rate (see Figure 7).. yielded the celebrated accelerationist hypothesis that 12 ECONOMIC REVIEW. 2 Actually. SS as expectations adjust to the trade-offs are inherently transitory phenomena. A higher stable rate of inflation could not ward-sloping lines are short-run Phillips buy a permanent drop in joblessness. combined with the error-learning process. unpredictability) that raises the natural P rate of unemployment. The natural rate of unemployment is therefore compatible with any constant rate of inflation provided it is fully anticipated (which it eventually must be by virtue of the error-learning weights adding to one). At. In sum. the right-hand side must also be zero at this point. according to the equation. The down- clear. p Price Inflation Rate b tion (the difference between actual and expected Short-run L inflation.returns to its natural (equilibrium) rate. This rate is compatible with all fully anticipated steady-state rates of inflation. That is. And equation 5 ensures that this latter condition must obtain for all steady inflation rates such that the of Unemployment ’’ long-run Phillips curve is a vertical line at the natural The vertical line L through the natural rate rate of unemployment.e. TO STEADY-STATE EQUILIBRIUM tion. Phillips curve to S.2 of unemployment UN is the long-run steady state Phillips curve along which all rates of The message of the natural rate hypothesis was inflation are fully anticipated. which implies that unemployment is at its natural rate.

Such acceleration. In other words. Therefore acceler- “’ r”” ‘s. I A 0 ’ U stant. Merely substitute equation 3 into the authorities could either peg unemployment or the expression presented in the preceding footnote to stabilize the rate of inflation but not both. But that same equation together with equation 4 implies that. ation is required to keep the gap open if unemploy.. that the deviation of U from U. they would lose control of the rate of inflation because the latter accelerates which says that the trade-off is between the rate of when unemployment is held below its natural level. This hypothesis. the long-run trade-off implied by the accelerationist hypothesis is between unem.. by the very nature of S2 B I the error-learning mechanism. They note8 that equation 3 posits that unemployment can differ from its natural level only so long as actual inflation deviates from ex. = b(p-pe) which says that the inflation rate must accelerate to stay ahead of expected inflation. unemployment at U. but instead stays con. level by the authorities such that its rate of change is zero. Fueled by progressively faster monetary % p Price Inflation Rate expansion.3 If I -1 inflation is not accelerated. Alternatively. ever-accelerating inflation. FEDERAL RESERVE BANK OF RICHMOND 13 . states that since there exists no long-run Figure 8 trade-off between unemployment and inflation. Thus attempts to peg natural rate and accelerationist propositions. a corollary of the natural rate concept. such deviations cannot Pl ‘I--- persist unless inflation is continually accelerated so that it always stays ahead of expected inflation. if they stabilized the inflation rate. thereby perpetuating the inflationary surprises that prevent unemployment from returning to its equilib- rium level (see Figure 8). C P2’ I--- pected inflation. First. then the gap between actual and expected inflation will eventually be closed. Long-run Vertical Q Accelerationists reached these conclusions via the P3’ I--- following route. Since the adjustment of expected to actual inflation works to restore unemployment to ployment and the rate of acceleration of the inflation its natural equilibrium level UN a t a n y rate. Natural Rate ment is to be maintained below its natural equilibrium of Unemployment 1 level. in contrast to the conventional trade-off between steady rate of inflation. such price acceleration would keep actual inflation always running ahead of expected infktion. perpetually and Accelerationist Hypotheses frustrates the full adjustment of expecta- tions that would return unemployment to At least two policy implications stemmed from the its natural rate. I -. then assuming the rate of inflation rising from zero to p. The economy will travel the path ABCD with 3 Taking the time derivative of equation 3.dominated many policy discussions in the inflationary 1970s. and then substituting equation 4 into the resulting expression yields . the authorities must unemployment and the inflation rate itself as implied continually raise (accelerate) the inflation by the original Phillips curve. If they obtain i = ba(U.-U) pegged unemployment. by generating a continuous Policy Implications of the Natural Rate succession of inflation surprises. 4The proof is simple. at- tempts to peg the former variable below its natural THE ACCELERATIONIST (equilibrium) level must produce ever-increasing HYPOTHESIS inflation.4 rate if they wish to peg unemployment at some arbitrarily low level such as U. will provoke explo- sive. is pegged at a constant to p2 to P3 etc. acceleration of inflation i and unemployment U relative to its natural rate.

5 The equations also indicate hypothesis is refuted and a long-run trade-off that how fast inflation comes down depends on the exists. This expression says that expectations will be adjusted Besides showing that the long-run Phillips curve is downward (. contrary to the original NATURAL RATE HYPOTHESIS Phillips hypothesis.e will be negative) only if unemployment steeper than its short-run counterpart (since the slope exceeds its natural rate. between inflation and unemployment so that the looked was the fact that controls would have little impact trade-off vanishes (see Figure 10). Aside from this. Conversely. Such is one. Thus. Over.’ expected inflation equal to actual inflation as required for long-run equilibrium and solving for the actual rate of inflation yields s The proof is straightforward. i. Simply substitute equa- tion 3 into equation 4 to obtain (7) P = & (UN-U). they must lower The tests themselves were mainly concerned with inflationary expectations. Convincing the piblic would be difficult if controls had failed to stop inflation in the past. In long-run equilibrium. equation 7 shows that a long-run trade- that disinflation will occur at a faster pace the larger the off exists only if the expectations coefficient + is less unemployment gap. which means that there is no relation wage-price controls to hold actual below expected infla- tion so as to force a swift reduction of the latter. . they could not peg unemployment at a given constant rate of inflation. exceeds that of s Note that the equation developed in footnote 4 states the latter. contended that the tests contained statistical bias that 14 ECONOMIC REVIEW. however. a/(1-+). But this con- it is hard to see why controls should have a stronger clusion was sharply challenged by economists who impact on expectations than a preannounced.e. Suppose the authorities wished to move from a the way for the introduction of the alternative Qigh inherited inflation rate to a zero or other low rational expectations idea into Phillips curve analysis. Setting long time (see Figure 9) .e Much slack means fast expectations-augmented equation as adjustment and a relatively rapid attainment of the (6) P = a(UN-U)++pe inflation target. The fourth stage involved A second policy implication stemming from the statistical testing of that hypothesis. then the natural rate hypothe- slack raises unemployment above its natural level and sis is valid and no long-run inflation-unemployment thereby causes the actual rate of inflation to fall trade-off exists for the policymakers to exploit. But equations 3 and 4 state that the the price-expectations variable in the expectations- only way to lower expectations is to create slack augmented Phillips curve equation. latter returns to its natural level at any steady STATISTICAL TESTS OF THE rate of inflation. MARCH/APRIL 1985 . They could. p*=p. Thus the policy choice is between zero and one) attached to the price expectations vari- adjustment paths offering high excess unemployment able. of inflationary expectations and thus helped prepare tion. choose the steady-state inflation rate at Phillips curve analysis in which the natural rate hy- which unemployment returns to its natural level. than one. on expectations unless the public was convinced that the trend of prices when controls were in force was a reliable Many of the empirical tests estimated the coeffi- indicator of the future orice trend after controls were cient to be less than unity and concluded that the lifted. they would lose control of unemployment since the Iv. a major determinant of the estimating the numerical value of the coefficient on inflation rate. of course. the natural rate revision of the latter. led to criticisms choose from among alternative transitional adjust. natural rate hypothesis was invalid. If the coefficient is one. Analysts emphasized this fact by writing the amount of slack created. the slope 7 Controls advocates proposed a third policy choice: use term is infinite. $ = ba(U. To do so. as in equation 3. The preceding has examined the third stage of however. expected for a short time or lower excess unemployment for a inflation equals actual inflation..to mid-1970s.-U). But below the expected rate so as to induce a downward if the coefficient is less than one. parameter of the former. natural rate hypoth&is was that the authorities could conducted in the early. If the coefficient capacity or excess supply in the economy. of the adaptive-expectations or error-learning model ment paths to the desired steady-state rate of infla. a). pothesis was formed. demon- strated policy of disinflationary money growth. little slack means slug- gish adjustment and a relatively slow attainment of where + is the coefficient (with a value of between the inflation target. These tests. target inflation rate.

They pointed out that it postu- well be biased downward. average of past price experience with weights that dence of inadequate measures of expectations. a long time. lates naive expectational behavior. then estimated coeffi. are fixed and independent of economic conditions and FEDERAL RESERVE BANK OF RICHMOND 15 . it follows that point B will be reached faster via the high excess unem- ployment path ACB than via the low excess unemployment path ADEB. The choice is between high excess unemployment for a short time or low excess unemployment for a long time. holding as it does cients of less than one constituted no disproof of the that people form anticipations solely from a weighted natural rate hypothesis. If so. that the adaptive-expectations scheme is a grossly They further showed that if these proxies were in- appropriate measures of inflationary expectations inaccurate representation of how people formulate then estimates of the expectations coefficient could price expectations. the critics argued for the unobservable price expectations variable. lowering actual relative to expected inflation and thereby inducing the downward revision of expectations that shifts the short-run curve leftward until point B is reached. Figure 9 ALTERNATIVE DISINFLATION PATHS p Price Inflation Rate p Price Inflation Rate I SA L Long-run Vertical Phillips Curve Initial Short-run \ Phillips Curve for Expected Inflation pa ‘U High Excess / ’ ACB = Fast disinflation path involving high ADEB = Gradualist disinflation path involv- excess unemployment for a short ing low excess unemployment for time. Shortcomings of the Adaptive-Expectations These critics pointed out that the tests typically used Assumption adaptive-expectations schemes as empirical proxies In connection with the foregoing. Since the speed of adjustment of expectations depends upon the size of the unemployment gap. To move from high-inflation point A to zero-inflation point B the authorities must first travel along short-run Phillips curve SA. tended to work against the natural rate hypothesis. Rather they constituted evi.

Once again. For example. the critics Figure 10 contended that adaptive expectations are not wholly THE EXPECTATIONS rational if other information besides past price COEFFICIENT AND THE changes can improve inflation predictions. the Statistical tests of the natural rate hypo- thesis sought to determine the magnitude adaptive-expectations mechanism is implausible be- of the expectations coefficient @J in the cause of its incompatibility with rational behavior.g. however.. tional errors. According to equation 5. At first. Being different from the SteadyState true inflation-generating mechanism. rational forecasters will cease to use them. But it is unlikely that this and the like-that could be used to reduce expecta. the adaptive-expectations model would systematically underestimate the inflation rate in the former case and overestimate it in the latter. economic structure. say. or inflation- change rate movements. condition would persist. a coefficient of less than one signifies the The shortcomings of the adaptive-expectations existence of a long-run Phillips curve trade approach to the modeling of expectations led to the off with negative slope for the policymakers incorporation of the alternative rational expectations to exploit. The discrepancy between actual and expected inflation would persist in a per- fectly predictable way such that forecasters would be provided free the information needed to correct their mistakes. ex. Using a unit weighted average of past inflation rates to forecast a steadily rising or falling rate would yield a succes- sion of one-way errors. money growth rate changes. price forecasting errors might also policy actions. Conversely. Perceiving these persistent expecta- tional mistakes. this means that forecasting errors ultimately could arise only from random (unforeseen) shocks occurring to the economy.-U). LONG-RUN STEADY-STATE Many economists have since pointed out that it is PHILLIPS CURVE hard to accept the notion that individuals would con- ‘tinually form price anticipations from any scheme p Price Inflation Rate that is inconsistent with the way inflation is actually I Long-run generated in the economy. such schemes Phillips Curve: will produce expectations that are systematically wrong. individuals will favorable than temporary ones. If so. MARCH/APRIL 1985 . In short. V. new policy regime. announced policy intentions generating mechanism. tend to exploit all available pertinent information about the inflationary process when making their price forecasts. If true. indi- approach into Phillips curve analysis. For if the public were 16 ECONOMIC REVIEW. According to cating that permanent trade-offs are less the rational expectations hypothesis. It implies that people look only at arise because individuals initially possess limited or past price changes and ignore all other pertinent incomplete information about. rational individuals would quickly abandon the error-learning model for more accurate expectations-generating schemes. That people would fail to exploit infor- mation that would improve expectational accuracy seems implausible. lonprun steady-state Phillips curve equation P= * (U. of course. Note that the long-run curves are steeper than the short-run ones. an unprecedented information-e. A coefficient of one means that no perma- nent tradeoff exists and the steady-state FROM ADAPTIVE EXPECTATIONS TO Phillips curve is a vertical line through the RATIONAL EXPECTATIONS natural rate of unemployment. suppose inflation were actually accelerating or decelerating.

however. such correlations already continuously) the transition to price stability should having been perceived and exploited in the process of improving price forecasts. cause rules defining the authorities’ response to changes in them to deviate from their natural equilibrium levels. As for disinflation strategy. the policy rule. i. tionary surprises or prediction errors (data on which are predictable. In systematically eradicated. The only conceivable way that policy can have even a short-run influence on real variables is for it Policy Implications of Rational Expectations to be unexpected. the policymakers must either act in an unpredictable random fashion or secretly The strict (flexible price. the policy authorities should be able to do so may be impossible if the public can predict policy without creating a costly transitional rise in unem- actions. there is no way the rate Phillips curve equations. forehand by making appropriate adjustments to nomi- verge to its rational expectations equilibrium and nal wages and prices. tions approach generally calls for a preannounced gence between actual and expected inflation.e. to the extent they are systematic.. Apart from such tactics. instantaneous market change the policy rule. As knowledge of policy other words. ployment. Once they know the rule. pations. forecasting vations on the behavior of the authorities to discover models would be continually revised to produce more accurate predictions. they will have no impact on those implied by the actual inflation-generating mech. the economy-cannot influence real variables such as The authorities can. rationality implies that current expecta- tional errors are uncorrelated with past errors and with also that wages and prices adjust to clear markets all other known information.g.e. ment. This it. rate (e. real variables like unemployment since they will have anism. i. Hav- a (UN-U).truly rational. be relatively quick and painless (see Figure 11). given that rational expectations adjust infinitely faster than adaptive expectations to a credible preannounced disinflationary policy (and 8 Put differently. Soon all systematic (predict. and individuals’ the policymakers respond to predict future policy price expectations would constitute the most accu. For. As incorporated in natural rate Phillips curve been discounted and neutralized in advance. zero) is desired. moves. they can) able) elements influencing the rate of inflation would use current observations on the variables to which become known and fully understood. it would quickly learn from these infla. when stabiliza- people’s price expectations would be the same as tion actions do occur. i. variable.. they rate (unbiased) forecast consistent with that knowl. Policy actions..e.* When this happened the economy would con. To have an impact on output and employ. Then. the rational expectations hypothesis implies rules-based policies. In short. can correct for the effect of anticipated policies be- edge. the source of These policy response functions can be estimated and forecasting mistakes would be swiftly perceived and incorporated into forecasters’ price predictions.. clearing) rational expectations approach has radical which are incompatible with most notions of the policy implications. on the basis of these predictions.e. When incorporated into natural proper conduct of public policy. Conseq’uently. To lower unemployment in the Phillips curve equation p-p”= inflation is sufficiently credible to be believed. will be perfectly anticipated to purely random shocks. models. and should con- since people would have already anticipated what the centrate their efforts on doing so if some particular policies are going to be and acted upon those antici. except for unavoidable surprises due by rational forecasters. rational individuals can use past obser- and the inflationary process improved. Systematic policies are simply feed- it acquires costlessly as a side condition of buying back rules or response functions relating policy vari- goods) and incorporate the free new information ables to past values of other economic variables. the authorities must be able to create a diver. those based on feedback control authorities can influence real variables. This sharp swift reduction in money growth-provided of follows from the proposition that inflation influences course that the government’s commitment to ending real variables only when it is unanticipated. FEDERAL RESERVE BANK OF RICHMOND 17 . namely the inflation rate. influence a nominal output and unemployment even in the short run.. it implies that system- atic policies-i. the authorities must be able to alter the ing chosen a zero target rate of inflation and having actual rate of inflation without simultaneously causing convinced the public of their determination to achieve an identical change in the expected future rate. price expectations would always be correct and the economy would always be and for that reason will have no impact on unemploy- at its long-run steady-state equilibrium. being in the information set used that thereafter. into its forecasting procedures. the rational expecta- ment.

tations assumption combines with the natural rate hypothesis to yield the policy-ineffectiveness conclu- sion that no Phillips curves exist for policy to exploit No Exploitable Trade-Offs s Note that the rationat expectations hypothesis also rules out the accelerationist notion of a stable trade-off between unemployment and the rate of acceleration of the inflation To summarize. do not adjust instantaneously to elimi- COSTLESS DISINFLATION nate forecast errors arising from policy-engineered UNDER RATIONAL changes in the inflation rate. natural rate Phillips curve models. the authbrities will not be able to fool people by accelerating inflation or by existence of exploitable Phillips curve trade-offs in accelerating the rate bf acceleration. In so doing. nb the short run as well as the long. Indeed. being backward looking and slow to Figure 11 respond. short-run trade-offs exist because such expectations. If exnectations are formed consistentlv with the junction with the natural rate hypothesis. In sum. in con. The economy moves immediately from point A to point B on thevertical steady-state Phillips curve. etc.e Phillips curves may exist. This cannot happen under rational expectations where both actual and expected inflation adjust identically p Price Inflation Rate Steady-State and instantaneously to anticipated policy changes. monetary policy can generate unexpected inflation and conse- POLICY CREDIBILITY quently influence reel variables in the short run. denies the way inflatioi is actually generated. rate. accompanying transitory rise in unemploy- ment. With expectations EXPECTATIONS AND adapting to actual inflation with a lag. no role remains for systematic counter- Disinflation Path cyclical stabilization policy in Phillips curve models embodying rational expectations and the natural rate hypothesis. But they are purely adventi- tious phenomena that are entirely the result of unpre- dictable random shocks and cannot be exploited by policies based upon rules. the rationality hypothesis. Since the models teach that the full effect 0 U of rules-based policies is on the inflation rate. and full policy credibility. systematic policy cannot induce the expectational errors that generate short-run Phillips curves. I In short. Here is the basic prediction of VI. 18 ECONOMIC REVIEW. the rational expectations-natural rate model: that fully anticipated policy changes EVALUATION OF RATIONAL EXPECTATIONS (including credible preannounced ones) affect only inflation but not output and The preceding has shown how the rational expec- employment. wage/ their efforts on controlling that nominal inflation price flexibility. 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 Assuming expectational rationality. The only thing such policy can influ- Inflation Rate ence in these models is the rate of inflation which adjusts immediately to expected changes in money growth. to be sure. These propositions are demonstrated Stable prices theoretically lowers expected with the aid of the expository model presented in the and thus actual inflation to zero with no Appendix on page 21. under rational expectations. a variable since they cannot systematically influence preannounced permanent reduction in money growth to a level consistent with real variables. Under adaptive- expectations. MARCH/APRIL 1985 . it systematic policy will work if expectations are formed consistently with the way inflation is actually generated differs from the adaptive-expectations version of in the economy.

And with the public’s rational given regime. either through their ability to sell supe- the theory of price anticipations into accord with the rior forecasts or to act in behalf of those without rest of economic analysis. The same cannot be said Most of the criticism. Other critics insist. superior to rival explanations. an evaluation of that component is biased price expectations. affect actual but not ex- Criticisms of the Rational Expectations pected inflation and thereby change unemployment Approach relative to its natural rate in the (inverted) Phillips curve equation UN-U= ( l/a) (p-p”). that most rational expectations component in modern Phillips people are too naive or uninformed to formulate un- curve analysis. it brings forecasters. will ensure that the economy will behave as if people behave as rational optimizers in the production all people were rational. Alternatively. In this way they discover the and that people can quickly learn to predict regime actual inflation generating process and use it in form. economic analysis can hardly proceed without the In this sense. the rational expectations theory is rationality assumption. is directed not at for other expectations schemes. those expec. even in the short run. respond to events seen as purely random by the domness. the rational expectations hypothe. Despite its logic. not systematic. it seems inconceivable that systematic ex. In this case. the profit motive and information advantage. True. One can also note that the and purchase of goods. and profit by and better information than the public. an more plausible than theories that imply the opposite. i. suppose the authorities possess more surely notice the errors. exploitable short-run Phillips curve reemerges. Not being the rationality assumption per se but rather at identical to the expected value of the true inflation another key assumption underlying its policy- generating process. Having this the corrections. they can predict and hence competition would reduce forecasting errors to ran. public. behavior. cation of the uncontroversial assumption of profit it should assume the same regarding expectational (and utility) maximization and that. all of which imply that that expectational rationality cannot hold during the expectations may be consistently wrong. This is especially so when regime expectations of inflation being the same as the mean changes have occurred in the past. those schemes will produce biased ineffectiveness result. For consistency. delegate the responsibility for formulating rational pothesis is that it treats expectations formation as a forecasts to informed specialists and that professional part of optimizing behavior. enced such changes. Systematic mistakes are harder to that private forecasters possess exactly the same explain than is rational behavior. Overlooked is the coun- now in order. policymaker information or maneuverability advan- tage over the private sector. Against this is the counterargument that such tations are always accurate. in the choice of jobs. suppose that both the authorities sis still has many critics. however. Having experi- value of the inflation generating process. cies to reduce unemployment. however. terargument that relatively uninformed people often One advantage of the rational expectations hy. Somebody would For example. Any errors will their likely future occurrence. allow- Considering the profits to be made from improved ing some limited scope for systematic monetary poli- forecasts. Note that it does not claim that to understand such changes and learn to adjust to people possess perfect foresight or that their expec. plausible and that if it is violated then the policy tinually make the same mistakes seems intuitively ineffectiveness result ceases to hold.e. Critics hold that this assumption is im- But a theory that says that forecasters do not con. This assumption states Biased expectations schemes are difficult to justify theoretically. Some still maintain that and the public possess identical information but that FEDERAL RESERVE BANK OF RICHMOND 19 . Together. The latter assumes that same. since they are unforeseen by the public. and in rational expectations hypothesis is merely an impli- the making of investment decisions. Given the importance of the expectations are basically nonrational. pectational errors would persist. them. namely the assumption of no expectations that are systematically wrong. forecasters will be sensitive to tations cannot be wrong on average. however. be random. changes just as they learn to predict the workings of a ing price expectations. It is the transition to new policy regimes or other structural only theory that denies that people make systematic changes in the economy since it requires a long time expectation errors. nobody information and the ability to act upon it as do the really knows how expectations are actually formed. correct them. These policy responses will. What it does claim is changes and their effects are often foreseeable from that they perceive and eliminate regularities in their the economic and political events that precede them forecasting mistakes. in any case.. By so doing. authorities.

even if effec. tive. they has changed radically over the past 25 years as the note that fixed contracts permit monetary policy to notion of a stable enduring trade-off has given way have real effects only if those effects are so inconse. not only would they lessen the 20 ECONOMIC REVIEW. they could tion public rather than attempting to exploit the ad. Likewise. the two hypotheses do imply for policy is not to exploit informational and con. the predictions of the original Phillips curve analysis. are inappropriate. Activist policies In these ways. Taken together. the authorities are in a approach argue that feasibility alone constitutes in- position to lower real wages and thereby stimulate employment with an inflationary monetary policy. then the policy. cannot possibly generate contract duration is not invariant to the type of policy such errors. MARCH/APRIL 1985 .the latter group is constrained by long-term con. Finally. wages and prices are sticky and costly to adjust. when people have wide access to data through the news media and private data services. They point out that their very predictability. to the policy-ineffectiveness view that no such trade- quential as to provide no incentive to renegotiate off exists for the policymakers to exploit. if contractual tractual obligations from exploiting that information. to eliminate erratic expectations Phillips curve models similar to the one . the authorities could stabilize the price level makers should publish unbiased forecasts. that the government can contribute to economic sta- tractual constraints to systematically influence real bility by following policies to minimize the expecta- activity but rather to neutralize the constraints or to tional errors that cause output and employment to minimize the costs of adhering to them. Thus if deviate from their normal full-capacity levels. The proper role for policy is not to policies. example. direct their efforts at minimizing random and erratic vantage. adjusting prices. control. Policies should also be gocially beneficial. The chief conclusions dicted from preceding observable (and obvious) can be stated succinctly. The such monetary changes become ineffective when the former says that trade-offs arise solely from expec- contracts expire. however. And even then. In their view. Similarly. Indeed. And if the so as to eliminate the surprise inflation that generates policy authorities have informational advantages over confusion between absolute and relative prices and private individuals. contrary to Finally. sufficient justification for activist policies. tion of Phillips curve analysis. they insist that such policies. respectively. variations of the variables under the policymakers’ outlined in the Appendix of this article. contractual and informational con- hardly satisfy this latter criterion since their effective- straints are alleged to create output. critics have tried to demonstrate as influence real activity via deception but rather to much by incorporating such constraints into rational .and employment- ness is based on deceiving people into making expec- stimulating opportunities for systematic stabilization tational errors. Instru- existing contracts or to change the optimal type of mental to this change were the natural rate and contract that is negotiated. it and make it freely available. In so doing. For people form biased price forecasts. then For example. then the central authority should gather trol. They contend that policymaker VII. they question the tational errors while the latter holds that systematic whole idea of fixed contracts that underlies the sticky macroeconomic stabilization policies. the money stock. the two hypotheses being pursued but rather varies with it and thus imply that systematic demand management policies provides a weak basis for activist fine-tuning. With nominal wages fixed and In short. are incapable of influencing real activity. reduce information deficiencies. that leads to perception errors. That is. information advantages cannot long exist when gov- ernment statistics are published immediately upon CONCLUDING COMMENTS collection. and perhaps also to minimize the costs of Proponents of the rational expectations approach. The Phillips curve concept economic and political pressures. they note. by virtue of wage case for policy activism. they should make that informa. advocates of the rational expectations prices responding to money. suppose workers and employers make the authorities should minimize these price adjust- labor contracts that fix nominal wages for a longer ment costs by following policies that stabilize the period of time than the authorities require to change general price level. doubt that such constraints can restore the potency of activist policies and generate exploitable Phillips curves. the proper role On the positive side. More precisely. The preceding paragraphs have traced the evolu- and when even secret policy changes can be pre. if information is costly to collect variations in the monetary variables under their con- and process. rational expectations hypotheses.

such micro policies can lower the natural from output’s natural rate. The deviations disappear when tive) prices of their own products. namely a permanent reduc. by improving the existence of exploitable inflation-unemployment the efficiency and performance of labor and product trade-offs. Finally. and the values of all notes all information available when expectations are past and predetermined variables in the model. b APPENDIX A SIMPLE ILLUSTRATIVE MODEL The policy ineffectiveness proposition discussed in the growth rate of (demand adjusted) money m‘ Section V of the text can be clarified with the aid of a and a random shock variable E having a mean iex- simple illustrative model. the last unemployment. in the early 1960s by those who advocated structural tations school also notes that microeconomic struc. they expect other businessmen to be raising theirs and tion are equal but produce in excess of that level (thus then adjust that rate upward if demand pressure appears. UT and PT. I de- the policy reaction function. that one should look for agreement demand policies cannot. the natural rate-rational expec. Remembering that the expected values of the off between unemployment (relative to its natural random terms in those equations are zero. E is the expectations operator. E i t h e r interuretation vields the same result: exuecta- tion. desiring to maintain their constant-market- supply function stating that firms produce the normal share relative prices. Surprised by inflation.l Equa- yields the expressions tion 2 expresses the rate of inflation p as the sum of they treat the price increase as special to themselves and 1 There exists a current dispute over the proper inter. since money growth a policy reaction function or feedback control rule cannot be controlled perfectly by the feedback rule.number of forecasting mistakes that induce deviations markets. first calculate mathematical expectations of equations 2 Of these four equations. The model consists of four petted) value of zero. An alternative interpretation views pretation of the Phillips curve equation 1. so expand output. The rational the equation as a price-setting relation according to which expectations literature interprets it as an aggregate businessmen. they would reduce policy rate of unemployment and shift the vertical Phillips uncertainty as well. that inflation is generated by excess money growth augmented Phillips curve and transitory disturbances unrelated to money growth. It is on this tural policies can be used to achieve what macro point. ment and inflation rates from their predetermined target levels. A similar argument was advanced Besides the above. p and pe the actual and expected rates equation defines anticipated inflation p” as the mathe- of inflation. This view holds that firms mistake unanticipated tional errors. curve to the left.cause ouiput and unemployment to deviate general price increases for rises in the particular (rela. pushing U below UN) when fooled by unexpected infla. formed. authorities. the errors vanish. In essence. FEDERAL RESERVE RANK OF RICHMOND 21 . Note that the disturbance term p can also represent deliberate monetary surprises engi- Here U and UN are the actual and natural rates of neered by the policy authorities. Included in the set of available ances). namely an (inverted) expectations. Equation 3 says that the policy authorities ( 1 ) UN--u = (l/a>(p-pe)9 set the current rate of monetary growth in an effort a monetarist inflation-generating mechanism to correct last period’s deviations of the unemploy- ( 2 ) p = m+e. the slippage is denoted by the random variable p with a mean of zero that causes money growth to and a definition of rational inflation expectations deviate unpredictably from the path intended by the ( 4 ) P” = ELPIII. ( 3 ) m = c(U--1--U&--d(p--1-pT)+~. this equation says components. E and p are random error terms with mean information are the inflation-generating mechanism. values of zero. policies to shift the Phillips curve. To derive the policy ineffectiveness result. this step level) and surprise (unexpected) inflati0n. therefore. Also. between those who still affirm and those who deny tion in the unemployment rate. the first expresses a trade- and 3. from their natural levels. and the subscripts T and -1 denote target and previous period values of the attached variables. For. m the rate of nominal monetary growth matical expectation of the actual inflation rate con- per unit of real money demand (the latter assumed ditional on all information available when the expec- to be a fixed constant except for transitory disturb- tation is formed. raise their prices at the rate at which capacity level of output when actual and expected infla.

inflation-generating mechanism. This means that systematic (rules- based) monetary policies cannot affect the unemploy- ( 6 ) me = c(U-r-UT)-d(P-l-Pr) ment rate. In particular. and expectations are not rational. the strict (flexible price. m-me=p. market clearing) rational expectations-natural rate ministic (known) component of the monetary policy model depicted here implies t at expectational errors rule. That is. Phillips curves are totally adventitious phenomena generated 2 Note that both the monetary-surprise equation m-rne=p by unforeseeable random shocks and as such cannot and the price-surprise equation p-pe=c embody the famous orthononalitv oronertv according to which fore. under rational expectations and No Phillips curve trade-offs exist for systematic systematic feedback policy rules. the anticipated policy to exploit. steady-state equilibrium pre- only the unsystematic or unexpected random com. the forecast errors are independent of the past and predetermined values of all variables and of the systematic components of the policy rule and a Of course random policy could affect output. which state that. no transitory the reduced form equation. \ are the only source of departure from steady-state and 6 into equation 1 to obtain the reduced form equilibrium. is not a proper basis for public policy. expression and immune to systematic policy manipulation. be exploited by systematic policy even in the short cast errors m-me and pipe-are indepe:dent of (ortho. gonal to) all information available when the forecast is made.2 The systematic com. Randomness. Thus. run. the authorities could influence real activity by manipu- For if the errors were not independent of the foregoing lating the disturbance term c in the policy reaction func- variables. however. This is as it should be. continuous monetary growth which in turn is given by the deter. then information is not being fully exploited tion in a haphazard unpredictable way. 22 ECONOMIC REVIEW. The last step is to substitute equations 2.3 future rate of inflation equals the expected rate of To summarize. no disappointed expectations. wage/price adjustments. except for unpre- To see the policy ineffectiveness result. note that dictable random shocks. Only unexpected money growth matters. vails and systematic monetary changes produce no ponent of monetary policy. 5. short-lived. that such errors are random. In short. and (7) UN-U = (l/a) (d-p) therefore that rules-based policies can have no impact which states that deviations of unemployment from on real variables like unemployment since those its natural rate result solely from inflation surprises policies will be fully foreseen and allowed for in caused by random shocks. impacts on real economic variables. MARCH/APRIL 1985 . enters the surprises. 3. ( 5 ) pe = me a n d ponent is absent.