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Thursday, August 10, 2006

There is Too a Short-Run Phillips Curve

The editorial page of the Wall Street Journal says there's no short-run Phillips curve, i.e. no short-run tradeoff between inflation and measures of real aggregate activity such as GDP and unemployment. And there is criticism of the Fed for hinting that such a tradeoff exists:

A Pause That Digresses, Editorial, WSJ: The Federal Reserve has seemed unsure how to proceed on monetary policy for several months, and yesterday it proved it. The Fed's Open Market Committee decided not to raise interest rates again -- not because inflation is contained but because it says the economy is slowing. Uh, oh. Here we go again, back to the era of the Phillips curve, the economic theory that postulates a trade-off between inflation and unemployment. We thought Paul Volcker and Alan Greenspan had buried that notion years ago. But apparently it lives on like Arthur Burns's ghost in the attic of the Fed, ready to inhabit a new Chairman who has inherited an inflation and is afraid that breaking it will send the economy into recession.

If there is no short-run tradeoff between output/unemployment and inflation, then the WSJ editors should have no objection to the Fed raising the federal funds rate (i.e. cutting money growth) by whatever amount is necessary to hit, say, a 1% inflation rate in 3-6 months (with no short-run tradeoff, this amount of time isn't needed, but let's not be overly demanding). Rates of 15%, 20%, 25%? 50% if needed? No problem. It doesn't matter how high rates go, unemployment and output won't change in the short-run - so just get rid of inflation no matter how high rates need to go.

I bet the WSJ editors, and their readers in the business community, would worry about GDP falling. If so, they believe in a short-run Phillips curve no matter what they say in public. Their idea of the short-run might be a shorter time period than mine, and that can affect policy choices, e.g. how aggressive to move against inflation, but that's a matter of degree, not substance.

Update: PGL at Angry Bear follows up. I noted the following in comments to his post:

I thought about mentioning the 82 recession as an example of the SR tradeoff, the 82 recession is widely acknowledged as one of the clearest examples of a recession induced by tight monetary policy, but credibility issues also played a role there. There is a difference between a movement along a SRPC, and a shift in the SRPC. With credibility and a frictionless world, inflation can be removed costlessly - the SRPC shifts immediately with any change and keeps output at the natural rate. But without credibility, or with frictions (including information frictions), the SRPC becomes operative.

Lack of credibility helps to explain the severity of the 82 recession - the SRPC wouldn't shift until people believed the Fed was actually serious about fighting inflation contrary to recent experience and that took awhile.  I don't think credibility is a problem currently (though with a new Fed chair that could be questioned), but I think short-run rigidities are an issue and this is what moves the economy along the short-run PC. That puts me in the New Keynesian camp. I understand other schools of thought have different interpretations.

To claim fighting inflation is costless, or to say that there is no SRPC says such short-run rigidities do not exist. My point was that if in fact they don't exist, then why not call for getting rid of all inflation immediately.

I think the editors at the WSJ would acknowledge such rigidities, but likely argue they are quickly resolved (so no need for a policy intervention) - but my reading of the empirical evidence does not support that position. There is controversy here - see, for example, the recent NBER papers Rudd and Whelan (at FRB) and by Gali, Gertler, and Lopez-Salido (WP # 11788) for a debate over traditional New Classical views of the Phillips curve versus the New Keynesian hybrid Phillips curve used more recently.

Update: See here for more on the inflation-unemployment tradeoff.

    Posted by on Thursday, August 10, 2006 at 12:03 AM in Economics, Macroeconomics, Monetary Policy | Permalink  TrackBack (2)  Comments (7)


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