Home > Uncategorized > Is it time to ditch the natural rate hypothesis?

Is it time to ditch the natural rate hypothesis?

from Lars Syll

Fifty years ago Milton Friedman wrote an (in)famous article arguing that (1) the natural rate of unemployment was independent of monetary policy, and (2) trying to keep the unemployment rate below the natural rate would only give rise to higher and higher inflation.

The hypothesis has always been controversial, and much theoretical and empirical work has questioned the real-world relevance of the ideas that unemployment really is independent of monetary policy and that there is no long-run trade-off between inflation and unemployment.

Although Olivier Blanchard also has his doubts — after having played around with a ‘toy model’ and looked at the data — he lands on the following advice:

iwf-chefvolkswirt-olivierFailure of either of the hypothesis leads to a more attractive trade-off​ between output and inflation, and, in the presence of shocks, suggests a stronger role for stabilization policy. If the independence hypothesis fails, adverse shocks are more costly, and stabilization policy more powerful. If the accelerationist hypothesis fails, there is more room for stabilization policy​ to be used at little inflation cost.

Where does this leave us? It would be good to have a sense of … the specific channels at work. The empirical part of this paper has shown that we are still far from it. Thus, the general advice must be that central banks should keep the natural rate hypothesis (extended to mean positive but low values of b and a) as their baseline, but keep an open mind and put some weight on the alternatives. For example, given the evidence on labor force participation and on the stickiness of inflation expectations presented earlier, I believe that there is a strong case, although not an overwhelming case, to allow U.S. output to exceed potential for some time, so as to reintegrate some of the workers who left the labor force during the last ten years.

My own view on the subject is that the natural rate hypothesis does not hold water simply because the relations it describes have never actually existed. 

The only thing that amazes yours truly is that although this is pretty ‘common knowledge,’  so-called ‘New Keynesian’ macroeconomists still today use it — and its cousin the Phillips curve — as a fundamental building block in their models. Why? Because without it ‘New Keynesians’ have to give up their (again and again empirically falsified) neoclassical view of the long-run neutrality of money and the simplistic idea of inflation as an excess-demand phenomenon.

The natural rate hypothesis approach (NRH) is not only of theoretical interest. Far from it.

The real damage done is that policymakers that take decisions based on NRH models systematically implement austerity measures and kill off economic expansion. The unnecessary and costly unemployment that this self-inflicted and flawed illusion eventuates, is something its New Classical and ‘New Keynesian’ advocates should always be kept accountable for.

According to the  [NRH], unemployment differs from its natural rate only if expected inflation differs from actual inflation. If expectations are rational, we should see as many quarters when inflation is above expected inflation as quarters when it is below expected inflation. That suggests the following test of the [NRH]:

74-7495-LTNQ100ZBecause a decade contains 40 quarters, the probability that average expected inflation over a decade will be different from average​ actual inflation should be small. If the [NRH] and rational expectations are both true simultaneously, a plot of decade averages of inflation against unemployment should reveal a vertical line at the natural rate of unemployment … This prediction fails dramatically.

There is no tendency for the points to lie around a vertical line and, if anything, the long-run Phillips is upward sloping, and closer to being horizontal than vertical. Since it is unlikely that expectations are systematically biased over decades, I conclude that the  [NRH] is false.

Defenders of the [NRH] might choose to respond to these empirical findings by arguing that the natural rate of unemployment is time-varying​. But I am unaware of any theory which provides us, in advance, with an explanation of how the natural rate of unemployment varies over time. In the absence of such a theor, ​ the [NRH] has no predictive content. A theory like this, which cannot be falsified by any set of observations, is closer to religion than science.

Roger Farmer

So, yes, it is definitely time to ditch the natural rate hypothesis!

  1. December 31, 2017 at 4:21 am

    And then there’s the inconvenient fact that unemployment *averaged* 1.3% in Australia in the fifties and sixties, with other OECD rates not greatly higher. Inflation was around 3%. These numbers are regarded as impossible.

    But then so are financial market crashes impossible.

  2. José A. de Souza Jr.
    December 31, 2017 at 11:47 am

    Very good points, Geoff. Time to confront mainstream economics with the results of its own dynamics. That’s what I like about Professor Keen’s Minsky computer model: it blows away the *dogmas* of general equilibrium hypotheses so cherished by mainstream economists. And students don’t even have to be accomplished mathematicians to run it! So, let’s use the contemporary tools of mathematics at our disposal to expose mainstream economics for what it really is: purely and simply a lie, albeit a very well-disguised one by hitherto thick and virtually impenetrable mathematical ramparts. Just click your heels!

  3. Jan Milch
    January 1, 2018 at 3:36 pm

    Debunking the NAIRU myth-By: Matthew C Klein – Financiel Times

  4. January 2, 2018 at 4:33 am

    One of the flawed concepts Friedman was quick to promote with his NRH was the exaggerated importance of the “economic variable” we know as expected inflation.

    The assumption, of course, is that high inflation expectations will surely cause prices to go higher, apparently through a magical process that no one ever bothers to explain.

    My counter is this: if we are embracing an assumption that markets are generally price competitive, it really doesn’t matter what you expect is going to happen in the future. No one is going to give you the price you think you deserve because you feel your expenses are going to be higher next year; you’re only going to get the best price the market will bear, period.

    If you believe that markets are competitive, and most neoclassical apologists claim they are, then it makes no sense to speak of expectations or fears or hopes when it comes to price determination. All else equal, most buyers face budget constraints. You can’t spend more money on something unless you have the money to pay for it; otherwise, you are priced out of the market.

    The one big exception to this rule (that expectations have no impact on prices) occurs when speculators have access to cheap credit, which enables them to spend outside of their normal budget constraints. That is the one time when inflationary expectations can have an impact on current prices as they seek to hoard consumables to sell at a higher price later on.

    But there’s nothing automatic about this sort of development. If credit for such purposes was made very expensive by lending institutions, speculators would no longer see the enticing arbitrage opportunities they once thought there might be, and then we could take “expectations” off of the table as a topic of legitimate concern to central bankers.

    Yes, there is an incidental relationship between expectations and prices—that is ultimately dependent upon a third variable that can be manipulated—but not the direct causal relationship that many central bankers seem to assume.

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