DOCSLIB.ORG

Rational Expectations, the Real Rate of Interest, and the Natural Rate of Unemployment

Total Page：16

File Type：pdf, Size：1020Kb

Download full-text PDF Read full-text
Rational Expectations, the Real Rate of Interest, and the Natural Rate of Unemployment THOMAS J. SARGENT University of Minnesota Rational Expectations, the Real Rate of Interest, and the Natural Rate of Unemployment THE INTERACTION OF EXPECTED INFLATION and nominalrates of interest is a topic that has receivedits share of attentionsince Milton Friedman gave IrvingFisher's theory a prominentrole in his presidentialaddress to the AmericanEconomic Association in 1967.1The relationshipbetween interestand expectedinflation depends intricately on the interactionsof the real and financialsectors of the economy, so that the subjectof this paperlies in the domain of macroeconomicanalysis. Partial equilibrium analysiswon't do. Therefore,even thoughmy mainsubject is the relation- ship betweeninterest rates and expectedinflation, there is no way to avoid such mattersas the natureof the Phillipscurve, the way expectationsare formed,and, in some formulations,the sizesof variousinterest elasticities: those of the demandand supplyfor moneyand those of aggregatedemand and its components. Note: The researchunderlying this paper was financedby the FederalReserve Bank of Minneapolis,and earlier researchthat was an indirect input was supportedby the National Bureauof EconomicResearch. Neither institution is responsiblefor the paper's conclusions.I benefitedfrom discussionswith Neil Wallace,Arthur Rolnick, Christopher A. Sims, and membersof the Brookings panel, none of whom, however, can be held responsiblefor any errors.Thomas Turnerprovided valuable help with the calculations. 1. Milton Friedman,"The Role of Monetary Policy," AmericanEconomic Review, Vol. 58 (March 1968),pp. 1-17. One statementof Fisher'stheory can be found in Irving Fisher. The Theoryof Interest(MacMillan, 1930), pp. 399-451. 429 430 Brookings Papers on Economic Activity, 2:1973 Thus, considerIrving Fisher's theory. In one interpretation,it asserts that an exogenousincrease in the rate of inflationexpected to persistover a given horizonwill producean equivalentjump in the nominalyield on bonds of the correspondingmaturity. That assertionconcerns the way the whole economyis put together;in particular,it is aboutthe reducedform equationsfor nominalrates of interest.If it is to hold, variousrestrictions mustbe imposedon the parametersof the structuralequations of a macro- economicmodel, which in turnimply important restrictions on the reduced form equations for endogenousvariables besides the interest rate-for example, aggregateincome and prices, variablesthat properlyconcern policy makersmore than do nominalinterest rates. For example,in stan- dardIS-LM-Phillips curve models,2 the responseof the interestrate to an exogenous shock in expectedinflation, like the response to any other shock that affects aggregatedemand, is distributedover time.3 A once- and-for-alljump in expectedinflation eventually leaves the real rate of interestunaltered, but in the shortrun drives it down and outputUp.4 Only in the specialcase in whichthe LM curveis vertical,the IS curveis hori- zontal, or the short-runPhillips curve is vertical(price adjustments being instantaneouswhenever employment threatens to deviate from full em- ployment)does an increasein expectedinflation produce an immediate, equivalentjump in the nominal interestrate.5 These special sets of pa- rametervalues obviously impart a very monetaristor classical sort of behaviorto the model. On this interpretationof Fisher'stheory, all of the parametersinfluenc- ing the slopesof the IS, LM, and Phillipscurves are pertinent in evaluating its adequacy.Conversely, evidence that the theoryseems adequate contains indirectimplications about the parametersof the macroeconomicstruc- ture, and thereforemight have some clues relevantfor evaluatingthe relativeefficacy of monetaryand fiscalpolicies. 2. See, for example,Martin Bailey, National Incomeand the Price Level: A Study in Macrothieory(McGraw-Hill, 1962), especiallypp. 49-54, which contains a good exposi- tion of Fisher'stheory from the standpointof the standardmacroeconomic model. 3. This point has been made by EdwardJ. Kane, among others.See "The Rasche and AndersenPapers, A Commentby EdwardJ. Kane,"Journal of Money,Credit and Bank- ing, Vol. 5 (February1973), Pt. 1, pp. 39-42. 4. Some of Keynes'views about the effect of an increasein expectedinflation on in- terest and employmentare containedin John MaynardKeynes, The GeneralTheory of Employment,Interest and Money (Harcourt,Brace, 1936), pp. 141-43. 5. For example,see ThomasJ. Sargent,"Anticipated Inflation and the Nominal Rate of Interest,"Quarterly Journal of Economics,Vol. 86 (May 1972), pp. 212-25. ThomasJ. Sargent 431 While the precedingstatement of Fisher'stheory may be of interestin highlightingits macroeconomiccontent, the theory can be stated in an alternativeand less confiningform, whichprobably comes closerto what modernadherents to Fisher'sdoctrine have in mind. This statementis less confiningbecause its truthdoes not requireany restrictionson the magni- tudes of the slopes of the IS, LM, and short-runPhillips curves. Further- more, it does not involvepursuing the implicationsof an exogenousjump in expectedinflation. Instead, expectations of inflationare assumedto be endogenousto the systemin a veryparticular way: they are assumedto be "rational"in Muth'ssense6-which is to say that the public'sexpectations are not systematicallyworse than the predictionsof economic models. This amountsto supposingthat the public'sexpectations depend, in the properway, on the thingsthat economictheory says they oughtto. Beyond this, the alternativestatement of Fisher'stheory assumesthat the Phelps- Friedmanhypothesis of a naturalrate of unemploymentis true, and thus that no (systematic)monetary or fiscal policiescan producea permanent effecton the unemploymentrate.7 Given these two hypotheses(which are relatedto one another,since it seems impossibleto give the naturalrate hypothesisa properformal statement without invoking the hypothesisof rationality),it follows that the real rate of interestis independentof the systematic,or foreseen,part of the money supply,which therefore can in- fluencethe nominalrate only througheffects on expectedinflation. The notion that the real rate of interestis independentof the systematic part of the money supplyembodies the key aspect of Fisher'stheory ap- pealedto by Friedmanin his presidentialaddress. To obtainthis property for the real rate requiresno assumptionsabout the slopes of the IS, LM, and short-runPhillips curves, for rationalityand the naturalunemploy- ment rate hypothesisare sufficientto supportit. From this point of view, then,the importantthing is not the responseof the systemto an exogenous shift in expectedinflation. It is importantto determinethe relationshipthat the standardway of empiricallyimplementing Fisher's theory bears to the precedingstatement 6. John F. Muth, "Rational Expectations and the Theory of Price Movements," Econometrica,Vol. 29 (July 1961), pp. 315-35. Some very important implications of assumingrationality in Muth'ssense in certainkinds of models of forwardmarkets were pointed out by Paul A. Samuelson in his "Proof that Properly Anticipated Prices FluctuateRandomly," Industrial Management Review, Vol. 6 (Spring 1965), pp. 41-49. 7. See EdmundS. Phelps, InflationPolicy and UnemploymentTheory: The Cost-Benefit Approachto MonetaryPlanning (W. W. Norton, 1972), pp. 35-43. 432 Brookings Papers on Economic Activity, 2:1973 of the theory.Irving Fisher and most of his followers8have implemented the theoryby estimatinga model of the form =p + 7r + ut n T= wwi (pz -Pts-1)3 i=O wherert is the nominalrate of interest,p is a constant,7rt is the unobserva- ble expectedrate of inflation,pt is the logarithmof the pricelevel, wi and n are parameters,and ut is a randomerror assumedto be distributedin- dependentlyof past, present,and futurevalues of p. Thesetwo equations have typicallybeen combinedto yield the equation n -=E (A-4 + Ut + P3 i=O wi Pt-i-1) whichhas been estimatedby a variantof the methodof least squares.The wishave been interpretedas estimatesof the distributedlags by whichthe publicforms its expectationsof inflation.(Some of Fisher'sfollowers have addedsome regressorsin an effortto improvehis equation.9) Generallyspeaking, the resultsof estimatingthis equationhave reflected poorly on the model. For data extendingover very long periodsof time, estimatesof the wis depictextraordinarily long distributedlags, much too long to be useful in forming predictionsof inflation.Consequently, the estimatedwis do not seem to providea plausibledescription of the way peopleform expectations of inflation-at least if they do so in an informed way.'0 For this reason, Fisher'sempirical results have often been viewed with suspicion." 8. For example, see William E. Gibson, "Price-ExpectationsEffects on Interest Rates," Journalof Finance,Vol. 25 (March 1970), pp. 19-34, and WilliamP. Yohe and Denis S. Karnosky, "InterestRates and Price Level Changes, 1952-69," Federal Re- serve Bank of St. Louis, Review,Vol. 51 (December 1969), pp. 18-38. 9. For example, see Martin Feldstein and Otto Eckstein, "The FundamentalDe- terminantsof the InterestRate," Reviewof Economicsand Statistics,Vol. 52 (November 1970), pp. 363-75. 10. This point has been madeby PhillipCagan in Determinantsand Effects of Changes in the Stock of Money, 1875-1960 (ColumbiaUniversity Press for the National Bureau of Economic Research, 1965), pp. 252-59. 11. Nerlove has proposed comparingregressions of dependentvariables (like rt) on currentand lagged proxies for psychologicalexpectations (like pt, pt-i, . .) with the distributedlags
Load more

Recommended publications
  • A Study of Paul A. Samuelson's Economics
    Copyright is owned by the Author of the thesis. Permission is given for a copy to be downloaded by an individual for the purpose of research and private study only. The thesis may not be reproduced elsewhere without the permission of the Author. A Study of Paul A. Samuelson's Econol11ics: Making Economics Accessible to Students A thesis presented in partial fulfilment of the requirements for the degree of Doctor of Philosophy in Economics at Massey University Palmerston North, New Zealand. Leanne Marie Smith July 2000 Abstract Paul A. Samuelson is the founder of the modem introductory economics textbook. His textbook Economics has become a classic, and the yardstick of introductory economics textbooks. What is said to distinguish economics from the other social sciences is the development of a textbook tradition. The textbook presents the fundamental paradigms of the discipline, these gradually evolve over time as puzzles emerge, and solutions are found or suggested. The textbook is central to the dissemination of the principles of a discipline. Economics has, and does contribute to the education of students, and advances economic literacy and understanding in society. It provided a common economic language for students. Systematic analysis and research into introductory textbooks is relatively recent. The contribution that textbooks play in portraying a discipline and its evolution has been undervalued and under-researched. Specifically, applying bibliographical and textual analysis to textbook writing in economics, examining a single introductory economics textbook and its successive editions through time is new. When it is considered that an economics textbook is more than a disseminator of information, but a physical object with specific content, presented in a particular way, it changes the way a researcher looks at that textbook.
    [Show full text]
  • Debt-Deflation Theory of Great Depressions by Irving Fisher
    THE DEBT-DEFLATION THEORY OF GREAT DEPRESSIONS BY IRVING FISHER INTRODUCTORY IN Booms and Depressions, I have developed, theoretically and sta- tistically, what may be called a debt-deflation theory of great depres- sions. In the preface, I stated that the results "seem largely new," I spoke thus cautiously because of my unfamiliarity with the vast literature on the subject. Since the book was published its special con- clusions have been widely accepted and, so far as I know, no one has yet found them anticipated by previous writers, though several, in- cluding myself, have zealously sought to find such anticipations. Two of the best-read authorities in this field assure me that those conclu- sions are, in the words of one of them, "both new and important." Partly to specify what some of these special conclusions are which are believed to be new and partly to fit them into the conclusions of other students in this field, I am offering this paper as embodying, in brief, my present "creed" on the whole subject of so-called "cycle theory." My "creed" consists of 49 "articles" some of which are old and some new. I say "creed" because, for brevity, it is purposely ex- pressed dogmatically and without proof. But it is not a creed in the sense that my faith in it does not rest on evidence and that I am not ready to modify it on presentation of new evidence. On the contrary, it is quite tentative. It may serve as a challenge to others and as raw material to help them work out a better product.
    [Show full text]
  • The Econometric Analysis of Recurrent Events in Macroeconomics and Finance the ECONOMETRIC and TINBERGEN INSTITUTES LECTURES
    The Econometric Analysis of Recurrent Events in Macroeconomics and Finance THE ECONOMETRIC AND TINBERGEN INSTITUTES LECTURES Series Editors Herman K. van Dijk and Philip Hans Franses The Econometric Institute, Erasmus University Rotterdam The Econometric and Tinbergen Institutes Lectures series is a joint project of Princeton University Press and the Econometric Institute at Erasmus University Rotterdam. This series col- lects the lectures of leading researchers which they have given at the Econometric Institute for an audience of academics and students. The lectures are at a high academic level and deal with topics that have important policy implications. The series covers a wide range of topics in econometrics. It is not confined to any one area or sub-discipline. The Econometric Institute is the leading research center in econometrics and management science in the Netherlands. The Institute was founded in 1956 by Jan Tinbergen and Henri Theil, with Theil being its first director. The Institute has received worldwide recognition with an advanced training program for various degrees in econometrics. Other books in this series include Anticipating Correlations: A New Paradigm for Risk Manage- ment by Robert Engle Complete and Incomplete Econometric Models by John Geweke Social Choice with Partial Knowledge of Treatment Response by Charles F. Manski Yield Curve Modeling and Forecasting: The Dynamic Nelson- Siegel Approach by Francis X. Diebold and Glenn D. Rude- busch Bayesian Non- and Semi-parametric Methods and Applications by Peter E. Rossi
    [Show full text]
  • Economic Thinking in an Age of Shared Prosperity
    BOOKREVIEW Economic Thinking in an Age of Shared Prosperity GRAND PURSUIT: THE STORY OF ECONOMIC GENIUS workingman’s living standards signaled the demise of the BY SYLVIA NASAR iron law and forced economists to recognize and explain the NEW YORK: SIMON & SCHUSTER, 2011, 558 PAGES phenomenon. Britain’s Alfred Marshall, popularizer of the microeconomic demand and supply curves still used today, REVIEWED BY THOMAS M. HUMPHREY was among the first to do so. He argued that competition among firms, together with their need to match their rivals’ distinctive feature of the modern capitalist cost cuts to survive, incessantly drives them to improve economy is its capacity to deliver sustainable, ever- productivity and to bid for now more productive and A rising living standards to all social classes, not just efficient workers. Such bidding raises real wages, allowing to a fortunate few. How does it do it, especially in the face labor to share with management and capital in the produc- of occasional panics, bubbles, booms, busts, inflations, tivity gains. deflations, wars, and other shocks that threaten to derail Marshall interpreted productivity gains as the accumula- shared rising prosperity? What are the mechanisms tion over time of relentless and continuous innumerable involved? Can they be improved by policy intervention? small improvements to final products and production Has the process any limits? processes. Joseph Schumpeter, who never saw an economy The history of economic thought is replete with that couldn’t be energized through unregulated credit- attempts to answer these questions. First came the pes- financed entrepreneurship, saw productivity gains as simists Thomas Malthus, David Ricardo, James Mill, and his emanating from radical, dramatic, transformative, discon- son John Stuart Mill who, on grounds that for millennia tinuous innovations that precipitate business cycles and wages had flatlined at near-starvation levels, denied that destroy old technologies, firms, and markets even as they universally shared progress was possible.
    [Show full text]
  • QE Equivalence to Interest Rate Policy: Implications for Exit
    QE Equivalence to Interest Rate Policy: Implications for Exit Samuel Reynard∗ Preliminary Draft - January 13, 2015 Abstract A negative policy interest rate of about 4 percentage points equivalent to the Federal Reserve QE programs is estimated in a framework that accounts for the broad money supply of the central bank and commercial banks. This provides a quantitative estimate of how much higher (relative to pre-QE) the interbank interest rate will have to be set during the exit, for a given central bank’s balance sheet, to obtain a desired monetary policy stance. JEL classification: E52; E58; E51; E41; E43 Keywords: Quantitative Easing; Negative Interest Rate; Exit; Monetary policy transmission; Money Supply; Banking ∗Swiss National Bank. Email: [email protected]. The views expressed in this paper do not necessarily reflect those of the Swiss National Bank. I am thankful to Romain Baeriswyl, Marvin Goodfriend, and seminar participants at the BIS, Dallas Fed and SNB for helpful discussions and comments. 1 1. Introduction This paper presents and estimates a monetary policy transmission framework to jointly analyze central banks (CBs)’ asset purchase and interest rate policies. The negative policy interest rate equivalent to QE is estimated in a framework that ac- counts for the broad money supply of the CB and commercial banks. The framework characterises how standard monetary policy, setting an interbank market interest rate or interest on reserves (IOR), has to be adjusted to account for the effects of the CB’s broad money injection. It provides a quantitative estimate of how much higher (rel- ative to pre-QE) the interbank interest rate will have to be set during the exit, for a given central bank’s balance sheet, to obtain a desired monetary policy stance.
    [Show full text]
  • Inflation, Income Taxes, and the Rate of Interest: a Theoretical Analysis
    This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: Inflation, Tax Rules, and Capital Formation Volume Author/Editor: Martin Feldstein Volume Publisher: University of Chicago Press Volume ISBN: 0-226-24085-1 Volume URL: http://www.nber.org/books/feld83-1 Publication Date: 1983 Chapter Title: Inflation, Income Taxes, and the Rate of Interest: A Theoretical Analysis Chapter Author: Martin Feldstein Chapter URL: http://www.nber.org/chapters/c11328 Chapter pages in book: (p. 28 - 43) Inflation, Income Taxes, and the Rate of Interest: A Theoretical Analysis Income taxes are a central feature of economic life but not of the growth models that we use to study the long-run effects of monetary and fiscal policies. The taxes in current monetary growth models are lump sum transfers that alter disposable income but do not directly affect factor rewards or the cost of capital. In contrast, the actual personal and corporate income taxes do influence the cost of capital to firms and the net rate of return to savers. The existence of such taxes also in general changes the effect of inflation on the rate of interest and on the process of capital accumulation.1 The current paper presents a neoclassical monetary growth model in which the influence of such taxes can be studied. The model is then used in sections 3.2 and 3.3 to study the effect of inflation on the capital intensity of the economy. James Tobin's (1955, 1965) early result that inflation increases capital intensity appears as a possible special case.
    [Show full text]
  • After the Phillips Curve: 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.
    [Show full text]
  • O Robert Mundell Και Το Βραβείο Nobel Στα Οικονομικά
    SAE./No.178/April 2021 Studies in Applied Economics ROBERT MUNDELL, 1932-2021: AHEAD OF HIS TIME Miranda Xafa Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise Robert Mundell, 1932-2021: Ahead of his Time By Miranda Xafa About the Series The Studies in Applied Economics series is under the general direction of Professor Steve H. Hanke, Founder and Co-Director of the Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise ([email protected]). About the Author Miranda Xafa started her career at the International Monetary Fund in Washington in 1980 and moved on to senior positions in government and in the financial sector. In 1991-93 she served as chief economic advisor to Prime Minister Constantin Mitsotakis in Athens, and subsequently worked as a financial market strategist at Salomon Brothers and Citigroup in London. After serving as a member of the IMF’s Executive Board in 2004-09, she is now a senior scholar at the Centre for International Governance Innovation (CIGI). She holds a Ph.D. in Economics from the University of Pennsylvania and has taught economics at the University of Pennsylvania and Princeton University. 1 I met Bob Mundell in Washington in 1982, when I was already working at the International Monetary Fund, at a conference on the international monetary system. My first impression was the absolute confidence with which he expressed his views. When one of the participants in his panel claimed that the data did not confirm his views, he responded: "If the data do not confirm my views, then the data are wrong." I had the chance to follow his life and career, and to participate in the conferences he organized and chaired in the last two decades in his beloved Palazzo Mundell in Tuscany where he lived.
    [Show full text]
  • Interest-Rate-Growth Differentials and Government Debt Dynamics
    From: OECD Journal: Economic Studies Access the journal at: http://dx.doi.org/10.1787/19952856 Interest-rate-growth differentials and government debt dynamics David Turner, Francesca Spinelli Please cite this article as: Turner, David and Francesca Spinelli (2012), “Interest-rate-growth differentials and government debt dynamics”, OECD Journal: Economic Studies, Vol. 2012/1. http://dx.doi.org/10.1787/eco_studies-2012-5k912k0zkhf8 This document and any map included herein are without prejudice to the status of or sovereignty over any territory, to the delimitation of international frontiers and boundaries and to the name of any territory, city or area. OECD Journal: Economic Studies Volume 2012 © OECD 2013 Interest-rate-growth differentials and government debt dynamics by David Turner and Francesca Spinelli* The differential between the interest rate paid to service government debt and the growth rate of the economy is a key concept in assessing fiscal sustainability. Among OECD economies, this differential was unusually low for much of the last decade compared with the 1980s and the first half of the 1990s. This article investigates the reasons behind this profile using panel estimation on selected OECD economies as means of providing some guidance as to its future development. The results suggest that the fall is partly explained by lower inflation volatility associated with the adoption of monetary policy regimes credibly targeting low inflation, which might be expected to continue. However, the low differential is also partly explained by factors which are likely to be reversed in the future, including very low policy rates, the “global savings glut” and the effect which the European Monetary Union had in reducing long-term interest differentials in the pre-crisis period.
    [Show full text]
  • Some Unpleasant Monetarist Arithmetic Thomas Sargent, ,, ^ Neil Wallace (P
    Federal Reserve Bank of Minneapolis Quarterly Review Some Unpleasant Monetarist Arithmetic Thomas Sargent, ,, ^ Neil Wallace (p. 1) District Conditions (p.18) Federal Reserve Bank of Minneapolis Quarterly Review vol. 5, no 3 This publication primarily presents economic research aimed at improving policymaking by the Federal Reserve System and other governmental authorities. Produced in the Research Department. Edited by Arthur J. Rolnick, Richard M. Todd, Kathleen S. Rolfe, and Alan Struthers, Jr. Graphic design and charts drawn by Phil Swenson, Graphic Services Department. Address requests for additional copies to the Research Department. Federal Reserve Bank, Minneapolis, Minnesota 55480. Articles may be reprinted if the source is credited and the Research Department is provided with copies of reprints. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. Federal Reserve Bank of Minneapolis Quarterly Review/Fall 1981 Some Unpleasant Monetarist Arithmetic Thomas J. Sargent Neil Wallace Advisers Research Department Federal Reserve Bank of Minneapolis and Professors of Economics University of Minnesota In his presidential address to the American Economic in at least two ways. (For simplicity, we will refer to Association (AEA), Milton Friedman (1968) warned publicly held interest-bearing government debt as govern- not to expect too much from monetary policy. In ment bonds.) One way the public's demand for bonds particular, Friedman argued that monetary policy could constrains the government is by setting an upper limit on not permanently influence the levels of real output, the real stock of government bonds relative to the size of unemployment, or real rates of return on securities.
    [Show full text]
  • How the Rational Expectations Revolution Has Enriched
    How the Rational Expectations Revolution Has Changed Macroeconomic Policy Research by John B. Taylor STANFORD UNIVERSITY Revised Draft: February 29, 2000 Written versions of lecture presented at the 12th World Congress of the International Economic Association, Buenos Aires, Argentina, August 24, 1999. I am grateful to Jacques Dreze for helpful comments on an earlier draft. The rational expectations hypothesis is by far the most common expectations assumption used in macroeconomic research today. This hypothesis, which simply states that people's expectations are the same as the forecasts of the model being used to describe those people, was first put forth and used in models of competitive product markets by John Muth in the 1960s. But it was not until the early 1970s that Robert Lucas (1972, 1976) incorporated the rational expectations assumption into macroeconomics and showed how to make it operational mathematically. The “rational expectations revolution” is now as old as the Keynesian revolution was when Robert Lucas first brought rational expectations to macroeconomics. This rational expectations revolution has led to many different schools of macroeconomic research. The new classical economics school, the real business cycle school, the new Keynesian economics school, the new political macroeconomics school, and more recently the new neoclassical synthesis (Goodfriend and King (1997)) can all be traced to the introduction of rational expectations into macroeconomics in the early 1970s (see the discussion by Snowden and Vane (1999), pp. 30-50). In this lecture, which is part of the theme on "The Current State of Macroeconomics" at the 12th World Congress of the International Economic Association, I address a question that I am frequently asked by students and by "non-macroeconomist" colleagues, and that I suspect may be on many people's minds.
    [Show full text]
  • Interest Rates and Expected Inflation: a Selective Summary of Recent Research
    This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: Explorations in Economic Research, Volume 3, number 3 Volume Author/Editor: NBER Volume Publisher: NBER Volume URL: http://www.nber.org/books/sarg76-1 Publication Date: 1976 Chapter Title: Interest Rates and Expected Inflation: A Selective Summary of Recent Research Chapter Author: Thomas J. Sargent Chapter URL: http://www.nber.org/chapters/c9082 Chapter pages in book: (p. 1 - 23) 1 THOMAS J. SARGENT University of Minnesota Interest Rates and Expected Inflation: A Selective Summary of Recent Research ABSTRACT: This paper summarizes the macroeconomics underlying Irving Fisher's theory about tile impact of expected inflation on nomi­ nal interest rates. Two sets of restrictions on a standard macroeconomic model are considered, each of which is sufficient to iniplv Fisher's theory. The first is a set of restrictions on the slopes of the IS and LM curves, while the second is a restriction on the way expectations are formed. Selected recent empirical work is also reviewed, and its implications for the effect of inflation on interest rates and other macroeconomic issues are discussed. INTRODUCTION This article is designed to pull together and summarize recent work by a few others and myself on the relationship between nominal interest rates and expected inflation.' The topic has received much attention in recent years, no doubt as a consequence of the high inflation rates and high interest rates experienced by Western economies since the mid-1960s. NOTE: In this paper I Summarize the results of research 1 conducted as part of the National Bureaus study of the effects of inflation, for which financing has been provided by a grait from the American life Insurance Association Heiptul coinrnents on earlier eriiins of 'his p,irx'r serv marIe ti PhillipCagan arid l)y the mnibrirs Ut the stall reading Committee: Michael R.
    [Show full text]