Sunday, June 29, 2014

What Happened to the Phillips Curve ?

Here we go again. There is a blog discussion among Keynesian to New Keynesian economists on the cause of the new Classical & Rational expectations revolutions. I have been typing my usual comments. I will now try a post. The question is: how important was stagflation in causing the abandonement of old Keynesian models ? I basically agree with Simon Wren-Lewis this time.

The discussion I have read Simon Wren-Lewis, Mark Thoma, Paul Krugman, and Noah Smith

A glossary: I'm not sure the participants are using terms exactly the same way. I will explain how I use them.

1. New Classical to me refers both to models based on the Lucas supply function and to real business cycle models. I think Mark Thoma used the phrase to refer only to the Lucas Supply function which explains why he says new classical models have been abandoned.

2. Stagflation: I think this generally refers to high inflation and high unemployment at the same time. Importantly, I don't think the word implies inflation which will remain high forever and ever so long as unemployment remains normal or low (at or below the NAIRU).

3. Stable Phillips curve: To correspond to the meaning of curve, this should mean the claim that inflation is best modelled as a function of unemployment plus a disturbance term (that is with no effect working through expected inflation)

4. The natural rate hypothesis is a claim that the long run Phillips curve is vertical at a natural rate of unemployment (which depends on labor market institutions)

Simon Wren-Lewis argues that stagflation could easily be reconciled with the old Keynesian approach (and notes that it was) so the change must have been caused by something else. He believes the cause was economists' attraction to rational constrained maximization.

There is a much simpler reading. Just as the original Keynesian revolution was caused by massive empirical failure (the Great Depression), the New Classical revolution was caused by the Keynesian failure of the 1970s: stagflation. [skip] I just do not think that is right. Stagflation is very easily explained: you just need an ‘accelerationist’ Phillips curve (i.e. where the coefficient on expected inflation is one), plus a period in which monetary policymakers systematically underestimate the natural rate of unemployment. You do not need rational expectations, or any of the other innovations introduced by New Classical economists. No doubt the inflation of the 1970s made the macroeconomic status quo unattractive. But I do not think the basic appeal of New Classical ideas lay in their better predictive ability. The attraction of rational expectations was not that it explained actual expectations data better than some form of adaptive scheme. Instead it just seemed more consistent with the general idea of rationality that economists used all the time. Ricardian Equivalence was not successful because the data revealed that tax cuts had no impact on consumption - in fact study after study have shown that tax cuts do have a significant impact on consumption. Stagflation did not kill IS-LM. In fact, because empirical validity was so central to the methodology of macroeconomics at the time, it adapted to stagflation very quickly.
I agree (except for the word "need" see below).

Mark Thoma agrees with Simon Wren-Lewis.

Paul Krugman wrote

I remember the 70s quite well, and stagflation did indeed play a role in the rise of new classical macro, albeit in a subtler way than the caricature that it proved Keynes wrong, or something like that. What mattered instead was the fact that stagflation had in effect been predicted by Friedman and Phelps; and the way they made that prediction was by taking a step in the direction of microfoundations. [skip] What this did was to give immense prestige to the notion that you could use the assumption of rationality to make better predictions than you could using historical experience alone.
I agree with this too except for the part about "What mattered"

Noah Smith agrees with Krugman.

My thoughts.

I am sure that Krugman recalls the 70s correctly (I arrived later but have similar recollections). However, I do not think that the perceptions in the late 70s about what Paleo Keynesians said in the 60s were accurate. Roughly I have seen no evidence that any prominent economist wrote anything which was proven false by the occurance of stagflation. Here, as often, I am retailing the research on recent history of thought by James Forder

I do not believe that any prominent Keynesian ever presented a model which was inconsistent with stagflation. It is widely believed that at some point Keynesians believed in a stable Phillips curve. This belief is not based on any primary sources.

I think that the immense prestige is based on an extraordinarily successful strategy of setting up and knocking down a straw man.

I think it is useful to see how the Old Keynesians responded to Lucas's supply function paper. I strongly recommend reading as a statement of the old Keynesian orthodoxy ( the twits ad Cowles have redone their indexation of old discussion papers (and failed to make old links link to new papges) so the above link is dead. The current link is . I can make no promises that it won't rot too.

This is prominent old Keynesian James Tobin summarizing a conference which happens to have included roughly the first presentation of the Lucas supply function outside of Chicago (except, as noted by Tobin in 1971, for the clear description in "The General Theory of Employment Interest and Money"). I note that Tobin agreed that Friedman was definitely right that eventually expected inflation would rise one for one with a permanent increase in inflation.

Second I think that a non accelerationist expectations augmented Phillips curve in which a permanent increase in lnflation of 1% causes an increase in expected inflation of 0.5% is consistent with stagflation (as I defined it above). An accelerationist Phillips curve is sufficient but not necessary. Let's say crazy monetary policy causes 30% inflation one year and 15% expected inflation the next year. According to the non accelerationist expectations augmented Phillips curve, enormous unemployment would be required to get actual inflation down to 10%. One might argue that actual data through the 70s refuted the 0.5 times lagged inflation model, but it just isn't true that any combination of high inflation and high unemployment refutes it. I know of no hint of any evidence that anyone ever believed that such a model is the truth and, in particular, was not convinced by the argument that a permanent increase in inflation must eventually cause a one for one increase in expected inflation. Simple models like the 0.5 model were estimated and used to forecast, because people thought they were false but useful -- reasonable approximations given the range of policies actually being considered -- that is because people used Friedman's methodology of positive economics.

Importantly the 0.5 model implies a downward sloping long run Phillips curve. It is also the sort of model which old Keynesians used in the 1960s.

Finally, it is consistent with the data through the 1970s. My estimate of that parameter using data through 1980q1 is

. reg ldwinf infcpi linfcpi unem if qtr<1980 ldwinf | Coef. Std. Err. t

infcpi | .4888773 .0642374 7.61

linfcpi | .0698199 .0748645 0.93

unem | -.1724548 .1291306 -1.34

_cons | .0518619 .0063418 8.18

This is roughly similar to estimates reported by 1971 (though not with my few variables from FRED). Ldwinf is the growth rate "Business Sector: Compensation Per Hour" over the following year, infcpi is CPI inflation over the preceding year, linfcpi is CPI inflation the year before that and unem is the standard unemployment rate. I used quarterly data so overlapping year long periods.

The controversy between Friedman and the Paleo Keynesians was whether the sum of coefficients on lagged inflation is one or less. Data from the 1970s do not answer this question.

The standard definition of "stagflation" is a combination of high inflation and high unemployment. This can occur in a 1960s era Keynesian model. Only after the fact did people (notably including Friedman who knew otherwise) come up with the idea that Paleo Keynesians didn't model expected inflation or assume that the Phillips curve shifts up at all with expected inflation.

Also 1960s era Keynesians agreed that Friedman was right about the long run -- that eventually an permanent increase in inflation would not cause inflation higher than expected inflation.

In 1971 Tobin agreed that this must be true. However, the US data from the 70s which allegedly proved Friedman right and someone else wrong doesn't prove that it is true.

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