Economic Review Federal Reserve Bank of San Francisco

Summer 1990 NUlIlber 3

Randall J. Pozdena Do Rates Still Affect Housing?

John P. Judd and What Does Tell Us Bharat Trehan About Future ?

William C. Gruben, Imperfect Information Jonathan A. Neuberger and Ronald H. Schmidt and the Community Reinvestment Act What Does Unemployment Tell Us About Future Inflation?

The level ofthe unemployment rate commonly is used as an indicator of future inflation. When unemployment is John P. Judd and Bharat Trehan judged to be below (above) its long-run, or "natural" rate, inflation is projected to rise (fall) in the future. This negative correlation between unemployment and inflation Vice President and Associate Director of Research, and is fundamental to the Keynesian, expectations-augmented Senior , Federal Reserve Bank of San Fran­ , which expresses inflation as a function of cisco. The authors would like to thank Jack H. Beebe and the unemployment rate relative to its long-run level, ex­ the members of the editorial committee, Chan G. Huh, pected inflation, and changes in certain relative such Brian Motley, and Carl Walsh, for helpful comments. as those of oil and the dollar. This interpretation of the relationship between unem­ ployment and inflation focuses primarily on the effects of demand factors, such as monetary and fiscal policies. In recent years, however, macroeconomic research increas­ ingly has incorporated such aggregate factors as changes in technology and the supply of labor in models of the behavior of the economy. "Real " The unemployment rate commonly is used as an indica­ models, in particular, attempt systematically to incorpo­ tor offuture inflation, with a low unemployment rate,for rate the effects of supply factors. As discussed below, this example, assumed to imply higher inflation. This negative real business cycle approach l suggests a positive correla­ correlation between current unemployment and future tion between unemployment and inflation. inflation assumes that aggregate demandfactors primarily Conceptually, the correlations between inflation and are responsible for movements in these variables. How­ unemployment implied by both the Phillips-curve and real ever, as discussed in this paper, changes in aggregate business cycle models may coexist. The observed relation­ supply conditions, such as technology and labor supply, ship in any given period thus depends on whether demand also cause movements in unemployment and inflation. or supply factors were the more influential during that These factors lead to apositive relationship betweenfuture period. Accordingly, in this paper we estimate amodel that unemployment and current inflation. Consequently, a treats unemployment and inflation as endogenous variables given rate of unemployment could be associated with that respond to both and aggregate almost any rate ofinflation, depending on the source of supply factors. the . In this paper, we attempt to disentangle de­ We find that both kinds of shocks are important in mand and supply shocks, and analyze their influence on explaining movements in inflation and unemployment, and unemployment and inflation in the post-World War II that both produce the well-known clockwise temporal U.S. economy. loops observed when the actual inflation rate is plotted against the actual unemployment rate. Thus these loops, which commonly are presented in macroecono~ic text­ books as arising from demand shocks in the context of the Phillips-curve relationship, also are consistent with supply shocks playing an important role. In addition, we find that while the effects of demand shocks on the unemployment

Federal Reserve Bank ofSan Francisco 15 rate reverse themselves in one to two years, the effects of inflation and unemployment that may be expected on a supply shocks last much longer, and appear to have been priori grounds in response to demand and supply shocks. responsible for large, persistent movements in the unem­ Section II discusses the econometric method we use to ployment rate. Finally, the fact that both demand and estimate demand and supply shocks, and presents some supply shocks play significant roles diminishes the useful­ evidence on the characteristics of these shocks. In Sec­ ness of the unemployment rate as an indicator of future tion III we present empirical estimates of how inflation and inflation, since policy makers must be able to identify the unemployment react to these shocks, and also the role source of a change in the unemployment rate before that played by the shocks in generating the observed correlation variable can be used to make a forecast of future inflation. between inflation and unemployment over the past 25 The remainder of the paper is organized as follows. years. Finally, Section IV discusses some policy impli­ Section I spells out the kinds of correlations between cations.

I. Inflation-Unemployment Correlations in Theory Keynesian theory stresses the role of aggregate demand tion a broad range ofother types of supply shocks, the most factors in causing business cycles, and focuses on capacity significant of which may be changes in technology and in bottlenecks caused by excess demand as the catalyst for the labor-leisure decisions of . Attempts to inflation. In this view, prices rise to relieve of incorporate factors into the Phillips curve labor and capital, and when accommo­ model have been ad hoc, and do not represent a com­ dates these pressures, inflation results. The expecta­ prehensive and systematic treatment of this aspect of tions-augmented Phillips curve embodies this hypothesis; economic behavior. 6 in this case, for a given level of expected inflation, the By contrast, real business cycle models attempt to difference between the prevailing rate of unemployment explain business cycles entirely on the basis of real devel­ and the bench-mark rate (the so-called "natural" rate) opments, such as shocks to labor supply and technology. 7 provides a measure of aggregate-demand pressures on These models de-emphasize demand factors in much the inflation. 2 same way that Keynesian models de-emphasize supply The inflation process can be illustrated with the follow­ factors. The real business cycle approach received con­ ing example. A positive induces firms to siderable impetus from the observation that the levels hire more workers. As the unemployment rate falls below of many real variables, including real GNP, contain the natural rate, labor markets become increasingly tight, permanent, random-walk-like components. 8 Given that and firms push up as they bid for labor. Faced with rising labor costs, firms raise product prices to maintain Chart 1 their mark-up over cost. 3 Thus, a decrease in the unem­ ployment rate is followed by higher inflation. Ultimately, Inflation and Unemployment however, the unemployment rate returns to its original Inflation 1965·1989 (long-run) level. 4 When the unemployment rate is graphed (Percent) against the inflation rate over time, this sequence of events 10 leads to clockwise loops similar to those shown in Chart 1. 9 Current research on the Phillips curve relationship also 8 allows some kinds of relative prices to affect the inflation 7 rate, such as changes in the relative price of oil and the real 6 foreign-exchange of the dollar. However, the Phillips '69 curve captures only the direct price effects of a change in 5 relative prices. By construction, it excludes possible ef­ 4 fects on the unemployment rate of supply shocks associ­ 3 '83 '86 ated with changes in relative prices. For example, a rise in 2-t-----,r----r---.----r--.--...------,.---, the price of oil not only can be expected to raise the 2 3 4 5 6 7 8 9 10 aggregate price , but also may raise the unemploy­ Unemployment ment rate. 5 Moreover, the Phillips curve omits by construc- (Percent)

16 Economic Review / Summer 1990 economic theory suggests that demand factors cannot tionship between inflation and the unemployment rate. permanently affect the levels of real variables, supply Whether the predicted co-movements are consistent with shocks, which can have permanent effects, must playa role the clockwise temporal loops shown in Chart I depends in explaining fluctuations in real GNP. upon the dynamic properties of the responses of inflation The simple model of aggregate demand and supply and unemployment to supply shocks. For instance, clock­ commonly used in macroeconomic textbooks can be used wise loops likely would result if the inflation rate re­ to illustrate how a supply shock would affect the correla­ sponded first to supply shocks, and the unemployment rate tion between inflation and output. A positive technology responded afterwards. Theory does not predict the exact shock, for instance, leads to an increase in aggregate dynamic pattern that will occur, so the question must be supply (that is, a rightward shift in the aggregate supply resolved empirically. curve), implying an increase in equilibrium output and a Real business cycle and Phillips curve models both fall in the . In a dynamic context, a rise in imply extreme views of the source of observed co-move­ aggregate supply would translate into lower inflation and ments in the inflation and unemployment rate data. Theory higher real GNP growth. does not rule out the possibility that both demand and Rigorously-derived real business cycle models that al­ supply factors operate simultaneously, and combine to Iowa role for also predict such a negative correla­ produce the data we observe. The magnitude of each tion between inflation and output. 9 Moreover, a positive factor's independent influence, then, is an empirical issue. (negative) technology shock will have sustained nega­ A balanced approach, in which neither demand nor supply tive (positive) effects on the unemployment rate in these factors are excluded, appears to be the most fruitful models as long as searching for labor is costly.lO For ex­ strategy for research. In the next section, we use an ample, a higher marginal product of labor (positive tech­ approach that is theoretically agnostic about the relative nology shock) raises the marginal benefit to searching importance of demand and supply factors, and instead uses for labor, and thus lowers the unemployment rate. the data to estimate the magnitudes of each of those Putting these elements together implies a positive rela- influences.

II. Estimates of Demand and Supply Shocks In assessing the major forces determining the inflation­ distinguish between capital and current expenditures and unemployment relationship, economic time series that the exclusion of the "revenues" generated by the inflation directly measure aggregate demand and supply shocks "tax",12 Other factors that can induce demand shocks­ would be most helpful. However, this is not possible in such as changes in the public's expectations of inflation most cases. or -also are difficult to measure Demand shocks can arise from a number of sources directly. including changes in monetary policy, , infla­ Similar problems exist in attempting to measure supply tion expectations, and consumer tastes, among others. shocks. These shocks originate from a variety of sources, Deregulation of the financial system has made the money including the development of new products (for example, supply (historically a good source of information on de­ computers), new ways to combine labor and capital more mand shocks emanating from Federal Reserve policy) a efficiently, changes in individuals' willingness to work, poor measure of these shocks. ll Interest rates might pro­ changes in tax laws, as well as sudden changes in the vide an alternative measure since they are influenced by relative prices of important inputs to production such as Federal Reserve actions. But because they also are influ­ oil. While certain taxes and relative prices can be meas­ enced by other factors such as fiscal policy, inflation ured directly, the other potential sources of supply shocks expectations, and aggregate supply, they are likely to be do not have direct empirical counterparts.J3 poor measures of monetary policy shocks as well. With respect to variables representing fiscal policy, Econometric Method there are major problems in the national income accounts An alternative approach to direct measurement is to that make it difficult to obtain conceptually appropriate estimate econometrically the demand and supply shocks measures of government activity, including the inability to that have influenced the aggregate macroeconomic time

Federal Reserve Bank of San Francisco 17 nterest Rates

5 20 tl'pf1p""i'l1 Reserve Bank of San Francisco Table 1 presents the associated variance decomposi­ Chart 3 tions, which show the relative importance of demand and Historical Decomposition supply shocks in explaining the unpredictable movements of Real GNP Growth in real GNP and the nominal . Demand shocks A) Effect of Supply Shocks account for slightly more than one half of the unpredictable variation in output one quarter ahead, and about one third (Percent) of that variation four quarters ahead. The remainder of the 4 variation is accounted for by supply shocks. Thus, both 3 demand and supply shocks play important roles in causing 2 short-run fluctuations in real output. However, by con­ 1 struction, the long-run movements in the level of real GNP o...... ~I---.ldl-++- are the result only of supply shocks. -1 With respect to movements in interest rates, in contrast, -2 demand shocks are much more important, accounting for -3 about three fourths of the unpredictable interest rate varia­ -4 tion one quarter ahead, and nearly all the variation at horizons of one year and beyond. -~ 960 1965 1970 1975 1980 1985 1990 Chart 3 shows the estimated quarter-by-quarter effects of demand and supply shocks on real GNP over the period from 1960:Q1 to 1989:Q3. 15 These effects seem broadly consistent with the conventional interpretation of the ma­ B) Effect of Demand Shocks jorevents in the period covered. As shown in the top panel, (Percent) supply shocks were responsible for much of the above 4 average during the 1960s, coinciding 3 with the well-known productivity surge in that period. They also played a role in the 1973-75 and 1980-82 2 , and may therefore be associated with the large 1 oil shocks in those periods. Consistent with the recent o history of monetary policy, the estimates shown in the -1 bottom panel suggest that contractionaryaggregate de­ -2 mand shocks played substantial roles in both the 1973-75 -3 and the 1980-82 recessions, and that an expansionary -4 demand shock was important in the late 1970s, when -~ inflation accelerated. 960 1965 1970 1975 1980 1985 1990

III. Explaining Unemployment and Inflation

Having obtained measures of the where 'ITt and ut denote the rates of inflation and unemploy­ shocks during the 1960-89 period, our objective is to ment, respectively, and d t and St are the (zero mean) assess the relative importance of each of these shocks in demand and supply shocks. The inflation equation con­ explaining movements in inflation and unemployment. For tains 16 lags of the supply shock variable and eight lags of this purpose, we estimated separate equations for unem­ the demand shock variable. These lag lengths were se­ ployment and inflation as functions of current and lagged lected by doing F-tests on the relevant variables, four lags values of the estimated demand and supply shocks. at atime. mt denotes the average rate ofM2 growth over the The equations are: prior five years. Itis included to allow the trend of inflation 16 8 to move over the sample. 16 The demand and supply shock 'TTt = i~oaiSt-i + i~oJ3idt-i + Omt (1) terms, then, explain deviations of inflation from the trend rate. Inclusion of m reduces the available sample size 4 8 (compared with the sample used for the VAR above) u = 'YiSt-i + 3 d - + AU - (2) t z=o.I z=o.I i t i t 1 because data for M2 begin only in 1959. Taking into

20 Economic Review / Summer 1990 + -i

Federal Reserve Francisco Chart 5 Dynamic Responses

A) To a Supply Shock B) To a Demand Shock (Percent) (Percent) 0.2 0.5

0.0 +------J.~====- 0.3 Unemployment Rate -0.2 0.1

-0.4 -0.1 Unemployment Rate Inflation

-0.6 -+-r-....--.-..,....,...... -r-l"""T"""'I...... -T-...... ,...... ~T"""T"'""'...... , -0.3 -t-r-...... ,.5...... -r0...... ~...,.15.....-...... -....,.20.....-...... ,...... ,...., 5 10 15 20 1 Quarters Quarters Chart 5presents the estimated responses of inflation and effects of a positive supply shock. The immediate response unemployment to (one-standard-deviation) positive de­ isa reduction in the inflation rate, after which unemploy­ mand and supply shocks. 18 These dynamic responses have ment gradually declines. The inflation rate moves back to the signs predicted by theory. A positive demand shock re­ its original level in two to four years after the shock, but duces unemployment and raises inflation, while a positive the unemployment rate takes much longer to get back to supply shock reduces both unemployment and inflation. its original level. Thus, even supply shocks lead to clock­ wise loops. Clockwise Loops As shown in the right-hand panel, a demand shock Chart 6 plots these dynamic responses in inflation­ initially has a larger impact on the unemployment rate. unemployment space. For illustrative purposes, we assume Unemployment reaches its minimum in less than a year, that the unemployment rate initially is 5.5 percent and the but by the end of the second year has risen back to its rate of inflation is 5.0 percent. The left panel shows the original level. The inflation rate rises as the unemployment

Chart 6 Dynamic Effects of Shocks on Unemployment and Inflation

Inflation Inflation (Percent) (Percent) B) Demand Shock 5.5 A) Supply Shock 5.5 1 Year 5.3 5.3 Before 5.1 10Yr. 15Yr. Shock 5.1 4.9 4.9 3Yr. 4.7 4.7

4.5 1 Year 1 Quarter 4.5 5.0 5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.0 5.1 5.2 5.3 5.4 5.5 5.6 5.7 Unemployment (Percent)

22 Economic Review / Summer 1990 rate declines, and remains high for nearly a year after the unemployment rate has returned to its original level. Thus, Chart 7 demand shocks produce the temporary -off predicted Dynamic Simulations Inflation by the Phillips curve. Note that the effects of supply shocks (Percent) A) Demand and Supply Shocks evolve more slowly and take longer to be completed than 10 those generated by demand shocks. '74 The loops in Chart 6 demonstrate why it is not possible 9 to develop simple rules of thumb to judge future inflation 8 based upon current observations of the level of unemploy­ 7 ment. Any given rate of unemployment could be followed 6 by almost any rate of inflation depending on the source of 5 the shock. Further, since the loops ultimately go back to '83 their starting points, a particular rate of unemployment 4 will be associated with different rates of inflation at 3 different points in time. 24----,.-----y--~---.----.---r-----..--, For similar reasons, changes in the unemployment rate 2 3 4 5 6 7 8 9 10 are unlikely to provide accurate information about future Unemployment changes in inflation. Consider, for instance, the left-hand (Percent) panel of Chart 6. A falling rate of unemployment may be followed either by rising inflation (as inflation moves back Inflation to its original level between the second and fourth years (Percent) B) Demand Shocks Only after the shock), or by no, change in inflation (as unemploy­ 10 ment gradually adjusts back to its original level after the fourth year). Thus, Chart 6 provides an illustration of the 9 '79 general principle that using one endogenous variable to 8 draw inferences about another endogenous variable can be 7 ~ a tricky enterprise. 6 Simulating Inflation-Unemployment Loops 5 Chart 7 presents dynamic simulations of unemployment 4 '71 and inflation over the 1965-89 period, using the historical 3 values of the estimated demand and supply shocks. The 2-+--r----,..--r------,.-----y--~----,.-....., first panel shows the effects of both kinds of shocks over 2 345 6 7 8 9 10 this period. The shape of our simulated loops is quite close Unemployment to the actual data shown in Chart 1. (Percent) The second panel shows how unemployment and infla­ tion would have evolved ifthere had been no supply shocks over this period. As expected, we obtain negatively sloped C) Supply Shocks Only loops, with the number of loops attesting to the relatively short period over which the effects of a demand shock dissipate. The third panel shows what would have happened if there had been no demand shocks over this period. The '83 plot shows little tendency to loop around and come back to its original position, reflecting the long-lived effects of supply shocks. Supply shocks have moved the unemployment rate and inflation over a much wider range than have demand shocks. Thus, they account for more long-run volatility in 2 9 10

Federal Reserve Bank of San Francisco 23 these variables. Supply shocks are estimated to have unemployment rate by nearly two percentage points in caused inflation and unemployment to move within ranges this period. that are 5.3 and 5.1 percentage points wide, respectively. The largest supply shocks occurred in 1973-74, 1979­ The comparable figures for demand shocks are 4.3 and 2.2 80, and 1983-86. The positive shock in the 1960s, presum­ percentage points. ably related to the large persistent productivity surge in In Section II, we discussed how our decomposition of those years, is mostly excluded by our 1965-89 sample movements in output into those caused by demand and period. 19 The 1973-75 and 1979-81 periods are associated supply shocks compared with conventional wisdom re­ with well known oil price shocks. According to our garding the events over our sample period. Using Chart 7, estimates, negative supply shocks raised inflation by about we can now repeat this exercise in terms of combinations ·1Y2 and two percentage points in these two periods, respec­ of inflation and unemployment. The largest movements tively, and raised unemployment by 2Y2 and lY4 percent­ that are estimated to have been caused by demand shocks age points. occurred in 1977-79, and in 1980-83. In the earlier period, A large positive supply shock shows up in 1983-86. widely recognized as one of excessively expansionary Any hypothesis concerning the source of this shock would monetary policy, the estimates suggest that demand shocks be especially speculative. However, the period roughly raised inflation by about 3Yz percentage points and lowered corresponds with the cut in marginal tax rates in the early the unemployment rate by about one percentage point. In 1980s, which some have suggested was a supply-side the latter period, the Federal Reserve adopted reserves­ source of rapid and increased work effort. In oriented monetary policy procedures to reduce inflation. addition, rapid technological change in personal comput­ We estimate that this negative demand shock reduced ing appears to have begun in the early 1980s, and this factor inflation by about 4Y2 percentage points and raised the could be related to the estimated positive supply shock.

IV. Policy Issues A major long-run goal of U.S. monetary policy is to The preceding discussion is not meant to suggest that the eliminate inflation. 20 One way to attempt to meet this goal Phillips curve model is inferior to other models of inflation is to use (formal or informal) forecasts offuture inflation to that are currently available. On the contrary, the Phillips judge the appropriateness of the current stance of monetary curve models appear to be at least as accurate at forecasting policy. For example, given the current stance of policy, a as the other available demand-side models. Stockton and forecast of inflation for any period in the future that exceeds Struckmeyer (1989), for example, support this conclusion the inflation goal would indicate that policy should be with tests of forecasts from Phillips curve, monetarist, and tightened. Our results suggest that the Phillips curve monetary-misperceptions models. We have focused on the model of inflation could provide misleading signals under Phillips curve in this paper simply because it is incorpo­ this forecast-oriented approach to policy. rated into the large Keynesian-style "structural" models The empirical importance of supply shocks as well as that are most widely used in macroeconomic forecasting. the long duration of their effects means that the unemploy­ Our major point is that there is good evidence that ment rate can remain above or below its steady state value aggregate supply factors, in addition to aggregate demand for long periods. 21 Consequently, to determine what a factors, affect inflation dynamics in complex ways. Models given rate of unemployment implies for future inflation, that ignore part or all of these supply factors run the risk of it is necessary first to determine the factors that are making large errors in episodes when these supply shocks responsible for the prevailing unemployment rate. When are important. analyzed in terms of the Phillips curve, supply-induced One response to this potential problem is to use an movements in the unemployment rate can lead to inap­ unrestricted for forecasting. VARs propriate policy actions. For example, a relatively low can capture both demand and supply factors, at least level of unemployment resulting from supply shocks offers insofar as the average behavior of these shocks over the little or no reason for concern about the potential for an estimation period applies to the forecast period. Thus, this acceleration of inflation. However, when viewed through approach may provide more accurate forecasts on average; the Phillips curve, such a change in the unemployment rate however, it appears susceptible to large errors in episodes would suggest that policy should be tightened. involving large, atypical shocks.

24 Economic Review / Summer 1990 Another response would be to develop a forecasting factors have been important in determining short- to inter­ model along the lines of the approach used in this paper. mediate-run macroeconomic developments over the past Whether this approach would be fruitful is uncertain, since three decades, it would seem worthwhile to explore ways we are not aware that any such model has been built. In any to disentangle the effects of these shocks in the context of event, given our finding that both demand and supply forecasting future economic developments.

NOTES

1. Plosser (1989) questions the usefulness of distinguish­ 12. For discussion of issues in measuring the budget ing between demand and supply shocks, as well as the deficit and further references, see Gramlich (1989), Barro identification of real business cycle models with supply (1989), Bernheim (1989), and Eisner (1989). factors. Instead, he prefers to make a distinction between 13. Boschen and Mills (1988) have attempted to relate real and nominal factors. real shocks to various economic time series. 2. For a discussion of the traditional Phillips curve, see 14. In an earlier paper, Judd and Trehan (1989), we used Gordon (1982). Ball, Mankiw and Romer (1988) discuss a five variable VAR to analyze unemployment rate dy­ the "new" Keynesian approach. Finally, for alternative namics. Using real GNP, the unemployment rate, a short­ theories concerning unemployment and inflation, see term nominal interest rate, the ratio of U.S. real exports to Lucas (1973) and Taylor (1980). imports, and working-age U.S. population, we allowed for 3. See Brayton and Mauskopf (1985) and Gordon (1982). four different kinds of shocks-domestic technology, la­ 4. For analysis of the theoretical basis for the natural rate bor supply, (two different) demand shocks, and a foreign of unemployment, seePhelps (1970). shock. That paper focused on relationships between these shocks and the unemployment rate, and did not 5. Within the context of afull Keynesian-style model, an oil explicitly analyze the inflation rate within the model. shock can have an effect on the unemployment rate. At given nominal interest rates, for example, an adverse oil 15. These effects are obtained by multiplying the coeffi­ price shock could reduce real GNP by lowering business cients in the impulse response functions by the appropri­ fixed investment and thus raise unemployment (via the IS ate historical shocks as measured by the model. We use a and Okun's law relationships.) Note, however, that the forecast horizon of 40 quarters for this purpose, which increase in unemployment would feed into the Phillips moves the starting date of our sample to 1960:01. curve like a demand shock: i.e., it would reduce inflation, 16. As noted earlier, financial deregulation has made the tending to offset the direct upward pressure on prices relationship between M2 and inflation more susceptible from the oil shock. to short-run disturbances. However, such disturbances 6, For example, the inclusion of the relative price of oil can be expected to be internalized within the five-year­ occurred when the Phillips curve relationship became average observations used in equation (1). unstable in the mid 1970s following the oil embargo. 17. Inclusion of the lagged dependent variable does not 7. For discussions of real business cycle models and lead to demand shocks having long-lived effects on the further references, see Plosser (1989) and Mankiw (1989). unemployment rate because the later lags on the demand shocks have negative coefficients. 8. Nelson and Plosser (1982). 18. The estimated impulse response functions for inflation 9. See Huh (1990) and Cooley and Hansen (1989). are noticeably jagged. Consequently, for the purposes of 10. For unemployment to exist in equilibrium business Charts 5 and 6, but not elsewhere in the paper, both the cycle models, we need to allow for heterogeneity of firms inflation and unemployment equations were re-estimated or workers, necessitating job search. For a discussion, after imposing smoothness priors. For a discussion of see Blanchard and Fischer (1989), pp. 346-350. these priors see Shiller (1973). 11. For a discussion of financial deregulation and its 19. As discussed above, the inclusion of M2 forces us to adverse effects on the stability of the monetary aggre­ shorten our sample period. gates, see Simpson (1984). These developments do not 20. See Greenspan (1990) and Parry (1990). imply, however, that there necessarily has been achange in the long-run relationship between M2 and inflation. 21. When interpreted within the context of a Phillips curve equation, these supply-induced movements in the unem­ ployment rate could appear to be changes in the so­ called natural rate of unemployment.

Federal Reserve Bank of San Francisco 25 REFERENCES Ball, Lawrence, N. Gregory Mankiw, and David Romer. Judd, John P. and Bharat Trehan. "Unemployment Rate "The New and the Output­ Dynamics: Aggregate-Demand and -Supply Interac­ Inflation Trade-off," Brookings Papers on Economic tions," Economic Review, Federal Reserve Bank of Activity, 1988.1. San Francisco, Fall 1989, pp. 20-38. Barro, Robert J. "The Ricardian Approach to Budget Kydland, F.E. and E.C. Prescott. "Time to Build and Deficits," The Journal of Economic Perspectives, Vol­ Aggregate Fluctuations," Econometrica, 50, 1982, ume 3, Number 2, pp. 37-54. pp. 1345-1370. Bernheim, Douglas B. "A Neoclassical Perspective on Lucas, Robert E. "Some International Evidence on Out­ Budget Deficits," The Journal of Economic Perspec­ put-Inflation Tradeoffs," American Economic Review, tives, Volume 3, Number 2, pp. 55-72. 63,1973. Blanchard, Olivier J. and Stanley Fischer. Lectures Mankiw, N. Gregory. "Real Business Cycles: A New on . Cambridge, Mass.: The MIT Keynesian Perspective," The Journal of Economic Press. 1989. Perspectives, Volume 3, Number 3, Spring 1989, Blanchard, Olivier J. and Stanley Fischer. Lectures on pp.79-90. Macroeconomics. Cambridge, Mass.: The MIT Press. Motley, Brian. "Has There Been a Change in the Natural 1989, pp. 520-23. Rate of Unemployment?," Economic Review, Federal Boschen, John F. and Leonard O. Mills.· "Tests of the Reserve Bankof San Francisco, Winter 1990, pp. 3-16. Relation Between Money and Output in the Real Busi­ Nelson, Charles R. and Charles I. Plosser. "Trends and ness Cycle Model," Journal of , Random Walks in Macroeconomic Time Series: Some 22,1988. Evidence and Implications," Journal ofMonetary Eco­ Brayton, Flint and Eileen Mauskopf. "The Federal Reserve nomics, 10, 1982. Board MPS Quarterly Econometric Model of the U.S. Parry, Robert 1. "Price Level Stability," FRBSF Weekly Economy," Economic Modeling, July 1985. Letter, Federal Reserve Bank of San Francisco, March Cooley, T.F., and GD. Hansen. "The Inflation Tax in a Real 2,1990. Business Cycle Model," American Economic Review, Phelps, Edmund S. Microeconomic Foundations of Em­ Summer 1989, pp. 733-48. ployment and Inflation. New York: w.w. Norton, 1970. Eisner, Robert. "Budget Deficits: Rhetoric and Reality," Plosser, Charles I. "Understanding Real Business Cy­ The Journal of Economic Perspectives, Volume 3, cles," The Journal of Economic Perspectives, Volume Number 2, pp.73-93. 3,1989, Number 3, pp. 51-77. Gordon, Robert J. "Inflation, Flexible Exchange Rates, Shapiro, Matthew D. and Mark W. Watson. "Sources of and the Natural Rate of Unemployment," in M. Bailey, Business Cycle Fluctuations," NBER Macroeconom­ ed., Workers, Jobs and Inflation. Washington, D.C.: ics Annual 1988, Cambridge, Mass.: M.IT Press. The Brookings Institution, 1982, pp. 89-158. Shiller, Robert J. "A Distributed. Lag Estimator De­ Gramlich, Edward M. "Budget Deficits and National Sav­ rived from Smoothness Priors," Econometrica, 1973, ing: Are Politicians Exogenous?," The Journal of Eco­ pp. 775-788. nomic Perspectives, Volume 3, Number 2, pp. 23-35. Simpson, Thomas D. "Changes in the Financial System: Greenspan, Alan. Testimony Before the Subcommittee Implications for Monetary Policy," Brookings Papers on Domestic Monetary Policy, House Committee on on Economic Activity, 1, 1984. Banking, Finance and Urban Affairs, U.S. House of Stockton, David J. and Charles S. Struckmeyer. "Tests of Representatives, February 20, 1990. the Specification and Predictive Accuracy of Non­ Huh, Chan G. "Output, Money and Price Correlations in a nested Models of Inflation," The Review ofEconomics Real Business Cycle Model," Working Paper 90-02, and Statistics, 1989, pp. 275-283. Federal Reserve Bank of San Francisco, May 1990. Taylor, John B. "Aggregate Dynamics and Staggered Contracts," Journal of , February 1980, pp. 1-23.

26 Economic Review / Summer 1990