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Persistence of High Inflation and High Unemployment

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Persistence of High Inflation and High Unemployment Conference Series No. 19 BAILY BOSWORTH FAIR FRIEDMAN HELLIWELL KLEIN LUCAS-SARGENT MC NEES MODIGLIANI MOORE MORRIS POOLE SOLOW WACHTER-WACHTER % FEDERAL RESERVE BANK OF BOSTON AFTER THE PHILLIPS CURVE: PERSISTENCE OF HIGH INFLATION AND HIGH UNEMPLOYMENT Proceedings of a Conference Held at Edgartown, Massachusetts June 1978 Sponsored by THE FEDERAL RESERVE BANK OF BOSTON THE FEDERAL RESERVE BANK OF BOSTON CONFERENCE SERIES NO. 1 CONTROLLING MONETARY AGGREGATES JUNE, 1969 NO. 2 THE INTERNATIONAL ADJUSTMENT MECHANISM OCTOBER, 1969 NO. 3 FINANCING STATE and LOCAL GOVERNMENTS in the SEVENTIES JUNE, 1970 NO. 4 HOUSING and MONETARY POLICY OCTOBER, 1970 NO. 5 CONSUMER SPENDING and MONETARY POLICY: THE LINKAGES JUNE, 1971 NO. 6 CANADIAN-UNITED STATES FINANCIAL RELATIONSHIPS SEPTEMBER, 1971 NO. 7 FINANCING PUBLIC SCHOOLS JANUARY, 1972 NO. 8 POLICIES for a MORE COMPETITIVE FINANCIAL SYSTEM JUNE, 1972 NO. 9 CONTROLLING MONETARY AGGREGATES II: the IMPLEMENTATION SEPTEMBER, 1972 NO. 10 ISSUES .in FEDERAL DEBT MANAGEMENT JUNE 1973 NO. 11 CREDIT ALLOCATION TECHNIQUES and MONETARY POLICY SEPBEMBER 1973 NO. 12 INTERNATIONAL ASPECTS of STABILIZATION POLICIES JUNE 1974 NO. 13 THE ECONOMICS of a NATIONAL ELECTRONIC FUNDS TRANSFER SYSTEM OCTOBER 1974 NO. 14 NEW MORTGAGE DESIGNS for an INFLATIONARY ENVIRONMENT JANUARY 1975 NO. 15 NEW ENGLAND and the ENERGY CRISIS OCTOBER 1975 NO. 16 FUNDING PENSIONS: ISSUES and IMPLICATIONS for FINANCIAL MARKETS OCTOBER 1976 NO. 17 MINORITY BUSINESS DEVELOPMENT NOVEMBER, 1976 NO. 18 KEY ISSUES in INTERNATIONAL BANKING OCTOBER, 1977 CONTENTS Opening Remarks FRANK E. MORRIS 7 I. Documenting the Problem 9 Diagnosing the Problem of Inflation and Unemployment in the Western World GEOFFREY H. MOORE 11 An Empirical Assessment of "New Theories" of Inflation and Unemployment STEPHEN K. McNEES 29 "New" Explanations of the Persistence of Inflation and Unemployment 47 After Keynesian Macroeconomics ROBERT E. LUCAS THOMAS J. SARGENT 49 Discussion BENJAMIN FRIEDMAN 73 Response to Friedman ROBERT E. LUCAS THOMAS J. SARGENT 81 Rebuttal BENJAMIN FRIEDMAN 83 Disturbances to the International Economy LAWRENCE R. KLEIN 84 Discussion JOHN F. HELLIWELL 104 Anti-Inflationary Policies in a Democratic Free Market Society BARRY BOSWORTH 117 Institutional Factors in Domestic Inflation MICHAEL L. WACHTER SUSAN M. WACHTER 124 Discussion MARTIN N. BAILY 156 Inflation and Unemployment in a Macroeconometric Model RAY C. FAIR 164 Discussion FRANCO MODIGLIANI 194 Ill. Summary and Evaluation 201 ROBERT M. SOLOW 203 WILLIAM POOLE 210 Opening Remarks Frank E. Morris It is probably fair to say that economic policy is now being made in at least a partial vacuum of economic theory. Unlike earlier periods, no one body of theory seems to have a very broad acceptance. If Keynesianism is not bankrupt, as Messrs. Lucas and Sargent suggest, it is at least in disarray. Certainly, the confidence that I felt as a member of the Kennedy Treasury in our ability to use the Keynesian system to generate outcomes for the economy which were highly predictable has been shaken, and I believe a great many other people have also lost that confidence. I look back with nostalgia on those years in the early sixties when we used, with remarkable success, small econometric models to make fairly exact estimates of what we needed to produce a given result in the economy. Now we have much more elaborate econometric models that are coming up with estimates in which we have much less confidence. Since the early sixties another school of theory, the Monetarist school, has flowered and most of us have learned a very great deal from it; however, at the same time, few of us are willing to accept the entire Monetarist body of theory. I have a feeling that the high water mark of Monetarism is already behind us. So with Keynesianism in disarray and Monetarism ebbing (if that is the case), we see a new school of theory evolving around the label of rational expectations. It is not clear just what this new school will generate that will be operational for policy-makers. Certainly, much of what it has generated as far as monetary policy is concerned is pretty much what we have already learned from the Monetarists - that the market is not a blank sheet of paper on which we can write with some confidence whatever we want. I think we have all learned that market feedback is something we must consider in formulating policy and we have seen such remarkable feedbacks recently in a sharp rise in the stock market after short-term interest rates rose by 3/4 of 1 percent. My only problem with the rational expectations school and the Lucas- Sargent paper is that they promise us a complete system ready for policy-makers in ten years. Obviously, ten years is a rather long time to wait; particularly for me, since ten years from now I will be on the verge of retirement. I am afraid that it will be a long time before we again have the complete confidence which we had in the early 1960s - that we knew exactly what we were doing. I await the return of such confidence. I think we are all looking for a new synthesis in economic theory. Historically we all know that such a new synthesis does not Frank Morris is President, Federal Reserve Bank of Boston. INFLATION AND UNEMPLOYMENT arise out of the brain of one man in a moment of great inspiration. We know from the history of Keynes’ general theory that it reflected the work of a great many people during the decade preceding his writing. Many people put together building blocks and pieces that contributed to the formation of the new syn- thesis. We are not expecting this meeting will generate the new synthesis that we are all seeking but perhaps it will generate one building block or two upon which a new synthesis will be based. Or perhaps a building block is already in place and will be revealed to us so that we can spread the gospel. That is the background upon which we can begin this investigation. Diagnosing the Problem of Inflation and Unemployment in the Western World Geoffrey Ho Moore The economic recovery following the recession of 1974-75 has left virtually every industrial country with higher unemployment rates than could be considered normal, as well as with l~igher inflation rates than could be considered desirable. In some countries, such as France, Italy, the United Kingdom and Canada, the unemployment rate in 1977 was as high as or higher than in 1973, the last year of general prosperity; but the inflation rate was higher also. In the United States, the unemployment rate also was higher in 1977 than in 1973, and the rate of inflation was only slightly lower. Only in West Germany and Japan, where unemployment was substantially higher in 1977 than in 1973, was the inflation rate substantially below what it had been in 1973, although even those countries with inflation at 4 to 5 percent had not achieved what they regarded as a satisfactory position with respect to inflation. Table 1 presents the unemployment and inflation rates for each of these countries for 1973, 1975, and 1977. Although it is easy to point to this anomaly, it is not easy to explain it, to say nothing of curing it. It is useful, however, to recall that it is not entirely new. Indeed, some 27 years ago Arthur Burns gave expression to the phenomenon in a single phrase that summed up a wealth of experience: "Inflation does not wait for full employment.’’~ He was describing the lessons distilled from Wesley Mitchell’s studies of business cycles, prior to World War II, and warning that economists might have to relearn this particular one. The advice was warranted then, and it is still relevant. Inflation has not waited for full employment, and those who thought there was no need to worry about inflation as long as there was considerable unemployment have had to learn the lesson the hard way. What I propose to do in this paper is to show how the situation can be described in a way that is more understandable, if not more palatable. Better understanding may lead to a more rational choice of policies that will effect a cure. What I shall do is examine the behavior of inflation during periods of slow Geoffrey H. Moore is Director, Business Cycle Research, National Bureau of Economic Research, Inc., and Senior Research Fellow, Hoover Institution, Stanford University. This statement represents the views of the author and is not an official report of the National Bureau. The paper draws extensively on one section of a paper prepared for Contemporary Economic Problems, edited by William Fellner, American Enterprise Institute, 1978. 1 Introduction to Wesley C. Mitchell’s What Happens During Business Cycles, National Bureau of Economic Research, 1951, p. xxi. 11 12 INFLATION AND UNEMPLOYMENT TABLE 1 Unemployment Rates and Inflation Rates in Seven Countries, 1973-77 Unem lpAp.yment Rate (%) I_nflation Rate~ CPI~ 1973 1975 1977 19.73 1975 1977 United States 5 8 7 9 7 7 Canada 6 7 8 9 10 10 United Kingdom 3 5 7 10 25 12 West Germany 1 4 4 8 5 4 France 3 4 5 8 10 9 Italy 3 3 3 13 11 14 J ap an 1 2 2 17 8 5 Average, 6 countries excluding United States 3 4 5 11 12 9 Source: Unemployment rates are from the U.S. Bureau of Labor Statistics and are adjusted to U.S. labor force concepts. See Joyanna Moy and Constance Sorrentino, "An Analysis of Unemployment in Nine Industrial Countries," Monthly Labor Review, April 1977, Table 2, p.
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