Niskanen, a companion piece to “A test of the demand rule”

That´s “On the death of the Phillips Curve”, written one year after “Demand rule”. What he argues in this article is that the 50 plus year search for a stable relation linking the nominal to the real side of the economy – the Phillips Curve – was mostly a waste of intellectual resources which, in addition, sowed confusion among macroeconomists, generations of students and many policymakers. The figure below is a stylized version of his figure 1 adding the years to 2010. What we see is a “shifting” object. If you tackle the dates to the points you see first a shift to the “northeast from the 1960s to the early 80s followed by a shift in the “southwestern” direction from the 1980´s to the 00´s. More recently, after 2007 it “shifted” in the “northwestern” direction into a region “previously unexplored”! (Note: In fact, as I´ll show, after 2007 the long term relation between inflation and unemployment that Niskanen found to be stable (and this is true up to 2007) became unstable in the last few years. In other words, the “Great Recession” has broken an almost 50 year old stable economic relation!) Next, Niskanen shows that the Friedman-Phelps formulation of the P-C postulates a relation between unemployment and changes in inflation. This formulation implies that unemployment would decline in response to an increase in inflation but would be invariant to any steady rate of inflation (Note: the New Keynesian P-C has “complicated” this formulation by postulating unemployment to depend on expected next period´s inflation). Anyway, the Friedman-Phelps formulation led to a search for the lowest level o unemployment that could be maintained without inflation increasing, i.e. the NAIRU (Non Accelerating Inflation Rate of Unemployment). Niskanen´s figure 2 (including data up to 2010 in this figure), indicates that the NAIRU is about 6%. But the figure also indicates that there has been a wide range of unemployment rates – less than 4% to 7% – consistent with little change in the inflation rate. So NAIRU is uncertain, which is not much help to policymakers, especially for the Fed in the pursuit of its dual mandate – maximum employment (lowest possible unemployment) and stable prices (stable and “low” inflation). More than being “not helpful” the facts have shown that it is “deceiving and dangerous”. Niskanen reminds us that in 1976 Nobel Lecture Friedman postulated (to the consternation of many at the time) that the P-C is positively sloped. That means there´s a long run significantly positive relation between unemployment and the inflation rate lagged one or two years. Niskanen´s figure 3 (again with data to 2010) follows. Recall that in the “demand rule” piece he starts of with the following statement:

It is important to recognize that a demand rule is consistent with any desired price-level path, including a stable price level. 

After specifying a very simple model that takes into consideration the long run positive relation between inflation and unemployment and taking account of the fact that unemployment adjusts gradually to its “equilibrium” value, Niskanen concludes (and that remains true including data to 2007):

The major lessons of this examination for macroeconomic policy are the following:

  • There is no tradeoff of unemployment and inflation except in the same year.
  • In the long term, the unemployment rate is a positive function of the inflation rate.
  • The minimum sustainable unemployment rate is about 3.7 percent, and can be achieved only by a zero steady-state inflation rate.

In conclusion, a monetary policy targeted to achieve a steady growth of aggregate demand at a zero inflation rate is also consistent with the lowest possible sustainable unemployment rate.

The monetary policy mistake of 2008 has (as shown in the last figure above) taken the economy far off it´s “natural” course. And in order to get even close to satisfying its dual mandate – hopefully by giving up the “inconsistent process of looking separately at inflation and employment and instead targeting NGDP along a level path -, the Fed has first to get the economy back close to the “track” from which it “dropped”.

4 thoughts on “Niskanen, a companion piece to “A test of the demand rule”

  1. It looks like the 3% growth path is the way to go.

    However, if it is really true that there is only a one year relationship between inflation and unemployment, doesn’t that imply that the adverse effect of the drop in the growth path should have disappeared after one year? Doesn’t that impy that the natural unemployment rate is 9.2% at this time?

  2. Very interesting post. Has anyone ever thought about unit labor costs? That they go down as production goes up (especially in high-overhead companies)?

    BTW, unit labor costs dropped in the last quarterly reading (in USA–BLS).

    We are fighting inflation as unit labor costs are declining. Figure that one out.

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