Ned Phelps’ ContributionsNed Phelps’ Contributionsas Viewed from Todayas Viewed from Today
through My Personal Filterthrough My Personal Filter
Robert J. Gordon, Northwestern Robert J. Gordon, Northwestern University and NBERUniversity and NBER
Presentation at OFCE, Paris,Presentation at OFCE, Paris,April 26, 2007April 26, 2007
Today’s Seminar is both on Today’s Seminar is both on Phelps and about my “filter”Phelps and about my “filter”
Where my implicit macro model started, Where my implicit macro model started, and how it was influenced by Phelps’ and how it was influenced by Phelps’ inventions and those of his co-authors and inventions and those of his co-authors and followersfollowers
My resistance to some ideas or My resistance to some ideas or treatments, and how these debates stand treatments, and how these debates stand todaytoday
Aided today by two critiques, Woodford’s Aided today by two critiques, Woodford’s 1994 review of 1994 review of Structural SlumpsStructural Slumps and and Akerlof’s 2007 Presidential AddressAkerlof’s 2007 Presidential Address
Even a Partial List of Phelps Even a Partial List of Phelps Contributions is AwesomeContributions is Awesome
Golden Rule of Capital AccumulationGolden Rule of Capital Accumulation Expectations-augmented Phillips CurveExpectations-augmented Phillips Curve Island Model of search unemploymentIsland Model of search unemployment Efficiency WagesEfficiency Wages Inflation targetingInflation targeting Models of staggered wage settingModels of staggered wage setting ““Customer market” model of price settingCustomer market” model of price setting Labor market hysteresisLabor market hysteresis Time inconsistent preferencesTime inconsistent preferences Macro analysis of supply shocks Macro analysis of supply shocks Structural SlumpsStructural Slumps
Look at the Names of the PeopleLook at the Names of the PeopleWho Have Picked Up the Ball Who Have Picked Up the Ball
that Ned Threwthat Ned Threw Golden Rule of Capital AccumulationGolden Rule of Capital Accumulation
Cass-KoopmansCass-Koopmans Expectations-augmented Phillips CurveExpectations-augmented Phillips Curve
EverybodyEverybody Island Model of search unemploymentIsland Model of search unemployment
Lucas, Mortensen, Mortensen-PissaridesLucas, Mortensen, Mortensen-Pissarides Efficiency WagesEfficiency Wages
Calvo, Shapiro-StiglitzCalvo, Shapiro-Stiglitz Inflation targetingInflation targeting
Taylor, SargentTaylor, Sargent
Continuing the list ofContinuing the list of“Followers”“Followers”
Models of staggered wage settingModels of staggered wage setting TaylorTaylor
““Customer market” model of price settingCustomer market” model of price setting OkunOkun
Labor market hysteresisLabor market hysteresis Blanchard, SummersBlanchard, Summers
Time inconsistent preferencesTime inconsistent preferences LaibsonLaibson
Macro Analysis of Supply Shocks (with Macro Analysis of Supply Shocks (with Gordon)Gordon)
Structural Slumps (with J-P F)Structural Slumps (with J-P F)
Ned had Many Children,Ned had Many Children,I will focus on TwoI will focus on Two
He founded New-classical Macro (with He founded New-classical Macro (with Friedman), leading to Lucas, Sargent, Friedman), leading to Lucas, Sargent, Sargent-Wallace, Barro, Kydland-PrescottSargent-Wallace, Barro, Kydland-Prescott
But he also was up at dawn in the But he also was up at dawn in the founding of the competing New-Keynesian founding of the competing New-Keynesian macro. Phelps-Taylor on staggered wage macro. Phelps-Taylor on staggered wage setting and Phelps-Gordon on the macro setting and Phelps-Gordon on the macro impact of supply shocks (often forgotten)impact of supply shocks (often forgotten) Supply shocks is not even in the index of the Supply shocks is not even in the index of the
Festschrift volume (!!) edited by Aghion, Festschrift volume (!!) edited by Aghion, Frydman, Stiglitz, WoodfordFrydman, Stiglitz, Woodford
A Few Other Children I A Few Other Children I AdmireAdmire
Labor-market churning as seen through Labor-market churning as seen through the lens of Mortensen-Pissaridesthe lens of Mortensen-Pissarides
Efficiency Wages and its Relation to Efficiency Wages and its Relation to Sticky WagesSticky Wages
Customer markets (Phelps-Winter) and Customer markets (Phelps-Winter) and the Okun distinction between auction the Okun distinction between auction and customer marketsand customer marketsWhat is the right theory of price stickiness?What is the right theory of price stickiness?
The A-Bomb Dropped on The A-Bomb Dropped on Keynesian Macro in 1968Keynesian Macro in 1968
What We Learned at MIT in 1964-68 was What We Learned at MIT in 1964-68 was summed up in the Modigliani/Ando-led Fed-MIT summed up in the Modigliani/Ando-led Fed-MIT macro modelmacro model
There was a permanent Phillips curve tradeoffThere was a permanent Phillips curve tradeoff In 1967 I was on a panel discussion, sanguine In 1967 I was on a panel discussion, sanguine
that inflation would not accelerate despite a that inflation would not accelerate despite a 3.5 percent unemployment rate3.5 percent unemployment rate
Fortunately Fortunately I did not do my PhD dissertation I did not do my PhD dissertation on macro!on macro! Otherwise it would have been instantly obsoleteOtherwise it would have been instantly obsolete
The Timing of the BombThe Timing of the Bombwas Importantwas Important
Friedman and Phelps introduced models Friedman and Phelps introduced models showing that there was no long-term showing that there was no long-term tradeofftradeoff
At first, some of us resisted with empirical At first, some of us resisted with empirical equations that claimed to show the equations that claimed to show the tradeoff still existedtradeoff still existed
The Friedman-Phelps timing was critical in The Friedman-Phelps timing was critical in this intellectual revolution, because the this intellectual revolution, because the American economy proved them right, American economy proved them right, almost instantlyalmost instantly
Let’s go back to 1968Let’s go back to 1968
Inflation was accelerating, breaking through Inflation was accelerating, breaking through every forecastevery forecast
Monetary policy was still targeting interest Monetary policy was still targeting interest ratesrates As inflation accelerated, real interest rates fell, As inflation accelerated, real interest rates fell,
fueling the firefueling the fire 18-month lag between LBJ’s economic advisers 18-month lag between LBJ’s economic advisers
advocating tax increase and the actual tax advocating tax increase and the actual tax surcharge of July, 1968surcharge of July, 1968
But the tax surcharge did not slow down the But the tax surcharge did not slow down the economy because of expansionary monetary policy economy because of expansionary monetary policy fueled by interest-rate targeting and accelerating fueled by interest-rate targeting and accelerating inflation that pushed down real interest ratesinflation that pushed down real interest rates
A firestorm happened to me in A firestorm happened to me in September, 1968September, 1968
Fresh from MIT (via Harvard), I arrived at the Fresh from MIT (via Harvard), I arrived at the University of Chicago in 9/68 as an assistant University of Chicago in 9/68 as an assistant professor with my Modigliani/MIT view of the worldprofessor with my Modigliani/MIT view of the world
I taught an advanced grad class in macro and was I taught an advanced grad class in macro and was shot down every day by a bunch of students who shot down every day by a bunch of students who knew more than I didknew more than I did Frenkel, Dornbusch, Mussa, Darby, Hugh McCulloch and Frenkel, Dornbusch, Mussa, Darby, Hugh McCulloch and
Rachel LarsenRachel Larsen No thanks to MIT, I had missed the Friedman-Phelps No thanks to MIT, I had missed the Friedman-Phelps
revolution and had to catch up fastrevolution and had to catch up fast Friedman’s Money Workshop made it easy to learn (Lucas Friedman’s Money Workshop made it easy to learn (Lucas
was still at Carnegie Mellon and Becker still at Columbia)was still at Carnegie Mellon and Becker still at Columbia) Why? Partly the Univ of Chi connection with Latin Why? Partly the Univ of Chi connection with Latin
America! How could there be a long-term tradeoff?America! How could there be a long-term tradeoff?
Why was the Friedman VersionWhy was the Friedman Versionof the NRH More Cited and of the NRH More Cited and
Popular?Popular? Friedman: A simple verbal model talked through Friedman: A simple verbal model talked through
but not written down in equationsbut not written down in equations Labor demand and supply curves, key innovation Labor demand and supply curves, key innovation
was the the LD curve depended on actual W/P, was the the LD curve depended on actual W/P, the supply curve of workers depended on the the supply curve of workers depended on the expected W/Pexpected W/Pee
Firms had the right price, workers the wrong Firms had the right price, workers the wrong expected price, workers were “fooled”expected price, workers were “fooled”
This became known as the “fooling model” and This became known as the “fooling model” and was converted into the rational expectations new-was converted into the rational expectations new-classical equilibrium model by Lucasclassical equilibrium model by Lucas We opponents immediately focused on the fooling, We opponents immediately focused on the fooling,
didn’t workers learn the CPI every month?!didn’t workers learn the CPI every month?! What about the Great Depression??What about the Great Depression??
The Phelps VersionThe Phelps Version Nominal disturbances have real effects because Nominal disturbances have real effects because
prices do not adjust instantlyprices do not adjust instantly There is no Walrasian “auctioneer” to coordinate There is no Walrasian “auctioneer” to coordinate
the re-setting of prices and wagesthe re-setting of prices and wages In 1967 and 1968 he introduced price and wage In 1967 and 1968 he introduced price and wage
expectations expectations as the key ingredient in decisions by as the key ingredient in decisions by workers and firmsworkers and firms
The business cycle then depended on deviations The business cycle then depended on deviations between actual and expected wages and pricesbetween actual and expected wages and prices
No special emphasis on workers being “fooled” by No special emphasis on workers being “fooled” by firms. Expectations mattered equally for workers firms. Expectations mattered equally for workers and firms, a “boom” meant inflation expectations and firms, a “boom” meant inflation expectations were were too low too low for everyone, not just workers. for everyone, not just workers.
As Interpreted by Akerlof As Interpreted by Akerlof (2007)(2007)
Phelps and Friedman deserved their Phelps and Friedman deserved their Nobel Prizes for switching from the Nobel Prizes for switching from the old Keynesian P Curve of the 1960s, old Keynesian P Curve of the 1960s, from depending of real U on nominal from depending of real U on nominal rates of change to real U depending rates of change to real U depending on changes in on changes in real wages and real real wages and real prices (relative to each other)prices (relative to each other)
But there were some negative But there were some negative consequencesconsequences
Phelps is Credited with BringingPhelps is Credited with BringingImperfect Info into Imperfect Info into MacroeconomicsMacroeconomics
But at a deeper level imperfect info is not the But at a deeper level imperfect info is not the core problem.core problem.
Unless we can explain the Great Depression, Unless we can explain the Great Depression, we’re not serious macroeconomistswe’re not serious macroeconomists
The Phelps-Friedman innovation claimed that the The Phelps-Friedman innovation claimed that the only only cause of the high unemployment of the cause of the high unemployment of the Great Depression was that people didn’t adjust Great Depression was that people didn’t adjust their expectations of inflation downward fast their expectations of inflation downward fast enoughenough
Does anyone think that US unemployment stayed Does anyone think that US unemployment stayed at 20-25% during 1933-34-35 because people at 20-25% during 1933-34-35 because people didn’t know the price level?didn’t know the price level?
Let’s go back to KeynesLet’s go back to Keynes
What Keynes Got RightWhat Keynes Got Right
Firms and workers are rationed; their sales Firms and workers are rationed; their sales and employment depend on effective and employment depend on effective demand.demand.
A worker with no choice of the wage or price A worker with no choice of the wage or price finds him/herself laid offfinds him/herself laid off
A firm finds the inventories piling upA firm finds the inventories piling up There is no “choice” about the amount to There is no “choice” about the amount to
produce or to work; it’s a produce or to work; it’s a CONSTRAINTCONSTRAINT A firm has no “choice” but to cut production A firm has no “choice” but to cut production
when sales evaporate. It has nothing to do when sales evaporate. It has nothing to do with incorrect expectations of the price levelwith incorrect expectations of the price level
The Neglected “Closed Closet” The Neglected “Closed Closet” of Keynesian Economicsof Keynesian Economics
Patinkin on the labor market, 1965; Clower Patinkin on the labor market, 1965; Clower on the product market at the same timeon the product market at the same time
Unified by Barro-Grossman Unified by Barro-Grossman AERAER in 1971, in 1971, their joint book in 1976their joint book in 1976
People are not making choices involving People are not making choices involving expectations. In this sense Phelps and expectations. In this sense Phelps and Friedman are responsible for pushing Friedman are responsible for pushing macroeconomics in the wrong direction for macroeconomics in the wrong direction for the last 40 yearsthe last 40 years
People are People are rationed, they are not choosingrationed, they are not choosing
Patinkin’s “Brick Wall”Patinkin’s “Brick Wall”
Critical Distinction between “Notional” Critical Distinction between “Notional” downward sloping labor demand curve and downward sloping labor demand curve and “Effective” labor demand curve constrained by “Effective” labor demand curve constrained by demanddemand
In a recession the effective labor demand curve In a recession the effective labor demand curve shifts left at the given W/P, pushing the brick shifts left at the given W/P, pushing the brick wall to the left. Workers can’t climb over it.wall to the left. Workers can’t climb over it.
No individual firm can climb over its wall eitherNo individual firm can climb over its wall either So the crucial issue is the source of wage and So the crucial issue is the source of wage and
price “stickiness” or “rigidity”. Keynes was right price “stickiness” or “rigidity”. Keynes was right and Phelps/Friedman pushed the wrong modeland Phelps/Friedman pushed the wrong model
Okun in 1970s Taught Us HowOkun in 1970s Taught Us Howto think about thisto think about this
What is the decision problem faced by firms and What is the decision problem faced by firms and workers in a recession?workers in a recession?
The Neoclassical paradigm is that all workers and The Neoclassical paradigm is that all workers and firms are fully employed but make bad decisions firms are fully employed but make bad decisions about expectationsabout expectations
In reality, nominal sales decline and nominal prices In reality, nominal sales decline and nominal prices and wages do not. Firms find fewer people walking and wages do not. Firms find fewer people walking into the sales room, and workers find themselves laid into the sales room, and workers find themselves laid offoff
They have no choice to do anything to save their They have no choice to do anything to save their sales or job. The workers can’t save themselves by a sales or job. The workers can’t save themselves by a personal, unilateral wage reduction because the personal, unilateral wage reduction because the entire system has a price level too high re nominal entire system has a price level too high re nominal GDP.GDP.
The “Daylight Saving Time” analogy to the The “Daylight Saving Time” analogy to the coordination failure. coordination failure.
The Standard “Modern Macro” The Standard “Modern Macro” Paradigm is WrongParadigm is Wrong
Neglects the “Coordination Failure” in the Neglects the “Coordination Failure” in the absence of perfect and instantaneous absence of perfect and instantaneous market clearing, total nominal flexibility of market clearing, total nominal flexibility of pricesprices
Ned was a leader in thinking about the Ned was a leader in thinking about the reasons for price and wage rigidity, but he reasons for price and wage rigidity, but he never integrated NMC into his mind setnever integrated NMC into his mind set
In the index of the Festschrift volume, In the index of the Festschrift volume, there is no mention of Benassy, Grossman, there is no mention of Benassy, Grossman, Malinvaud.Malinvaud.
Just Barro, but that is for the growth Just Barro, but that is for the growth empirical literature, not for non-market-empirical literature, not for non-market-clearing economicsclearing economics
Friedman/Phelps created Friedman/Phelps created New Classical Macro “Mark 1”New Classical Macro “Mark 1”
Because Friedman/Phelps had created the Because Friedman/Phelps had created the paradigm that business cycles were paradigm that business cycles were created by “expectational errors”created by “expectational errors”
This opened the way for Lucas to create a This opened the way for Lucas to create a world in which “rational expectations” world in which “rational expectations” would eliminate business cycles.would eliminate business cycles.
Lucas 1973 distinction between aggregate Lucas 1973 distinction between aggregate and local shocksand local shocks Neat and convincing: slope of Phillips curve Neat and convincing: slope of Phillips curve
was much steeper in Argentina than USwas much steeper in Argentina than US Culmination of connection of U Chicago with Culmination of connection of U Chicago with
Latin America, but Lucas was still at CarnegieLatin America, but Lucas was still at Carnegie
Something Interesting in 1973 Something Interesting in 1973 Quickly Became Crazy in 1975Quickly Became Crazy in 1975
If the only reason for business cycles is If the only reason for business cycles is expectational errors, this leads to the expectational errors, this leads to the Sargent-Wallace “policy ineffectiveness Sargent-Wallace “policy ineffectiveness proposition”proposition”
Monetary Policy cannot influence output Monetary Policy cannot influence output without doing something different from without doing something different from what agents expectwhat agents expect
All based on the “Lucas supply equation”All based on the “Lucas supply equation”Y = f(P-PY = f(P-Pee))
Thus the Great Depression occurred Thus the Great Depression occurred because people did not know the price because people did not know the price level or the nominal money supplylevel or the nominal money supply
New Classical Mark I Collapsed New Classical Mark I Collapsed in the Rubble of its Empiricsin the Rubble of its Empirics
Run a Regression of Real GDP on Run a Regression of Real GDP on differences between actual and differences between actual and expected inflationexpected inflation
Problem: Expectations can adjust to Problem: Expectations can adjust to eliminate errors within a few weeks or eliminate errors within a few weeks or months but business cycles last for months but business cycles last for yearsyears
Not just the Great Depression – Actual Not just the Great Depression – Actual real GDP was below natural real GDP real GDP was below natural real GDP for six straight years, 1981-86for six straight years, 1981-86
Robert Barro would preferRobert Barro would preferto forget this part of his careerto forget this part of his career
New Classical Mark I is market-clearing New Classical Mark I is market-clearing economics dependent on a rapid economics dependent on a rapid adjustment of prices to nominal shocksadjustment of prices to nominal shocks
Barro’s Empirical Work showed a four-Barro’s Empirical Work showed a four-year lag of nominal prices behind year lag of nominal prices behind nominal moneynominal money
These empirical results supported non-These empirical results supported non-market-clearing Barro-Grossman, not market-clearing Barro-Grossman, not Friedman-Lucas-PhelpsFriedman-Lucas-Phelps
The High Point at Bald Peak The High Point at Bald Peak NHNH
October 14, 1978October 14, 1978Barro presents his empirical results Barro presents his empirical results
on inflation showing long lags and on inflation showing long lags and denying New Classical Macro Mark Idenying New Classical Macro Mark I
Simultaneously, Lucas and Sargent Simultaneously, Lucas and Sargent announce that macroeconomics must announce that macroeconomics must be reconstructed starting from the be reconstructed starting from the rubble and wreckage of Keynesian rubble and wreckage of Keynesian EconomicsEconomics
Ned Came to Save Macro,Ned Came to Save Macro,Even if the Festschrift Volume Even if the Festschrift Volume
Didn’t NoticeDidn’t Notice
We’ll come back to staggered wage We’ll come back to staggered wage settingsetting
What was crucial in 1975 was the need for What was crucial in 1975 was the need for a theory to explain the positively sloped a theory to explain the positively sloped Phillips curvePhillips curve
New York TimesNew York Times in fall 1974, “Inflation in fall 1974, “Inflation Creates Recession”Creates Recession”
New-Classical Economics announced the New-Classical Economics announced the death of Keynesian Macro but they were death of Keynesian Macro but they were left up the creek without an explanationleft up the creek without an explanation
Simultaneous Gordon-PhelpsSimultaneous Gordon-PhelpsModel of Supply ShocksModel of Supply Shocks
I had the advantage of the I had the advantage of the Brookings Brookings Papers, Papers, published in 1975published in 1975
Ned published in the Ned published in the JMCBJMCB in 1978 in 1978 Same basic idea, although different in Same basic idea, although different in
details, integrated in my details, integrated in my AEA Proceedings AEA Proceedings paper in 1984paper in 1984
Price-inelastic demand means that a higher Price-inelastic demand means that a higher share of nominal GDP must be spent on share of nominal GDP must be spent on energy/food. energy/food.
A “wedge” must open up between nominal A “wedge” must open up between nominal GDP and nominal wage to “pay for” higher GDP and nominal wage to “pay for” higher percentage of GDP spent on energy and percentage of GDP spent on energy and food.food.
The New Macro Opened up The New Macro Opened up by Textbooksby Textbooks
Suddenly we had a unified macroSuddenly we had a unified macro The unemployment-inflation correlation could be The unemployment-inflation correlation could be
negative (demand shocks) or positive (supply negative (demand shocks) or positive (supply shocks)shocks)
Integration of aggregate AS-AD with micro AS-ADIntegration of aggregate AS-AD with micro AS-AD A new generation of textbooks worked this all out A new generation of textbooks worked this all out
(intermediate macro: Gordon and Dornbusch-(intermediate macro: Gordon and Dornbusch-Fischer 1978 and econ principles Baumol-Blinder Fischer 1978 and econ principles Baumol-Blinder 1979).1979).
They key diagram (SP-DG) can be traced to a They key diagram (SP-DG) can be traced to a classroom handout of Rudi Dornbusch in March classroom handout of Rudi Dornbusch in March 19751975
A Remarkable Sequence of A Remarkable Sequence of Events which Everyone has Events which Everyone has
ForgottenForgotten Lucas-Sargent in 1978 announced Lucas-Sargent in 1978 announced
Keynesian Economics was Dead on the Keynesian Economics was Dead on the basis of the positive U-inflation tradeoffbasis of the positive U-inflation tradeoff
Three years earlier, the theory had been Three years earlier, the theory had been developed by Gordon-Phelps to explain the developed by Gordon-Phelps to explain the possibility of a positive U-inflation tradeoffpossibility of a positive U-inflation tradeoff
Textbooks and econometrics (Gordon Textbooks and econometrics (Gordon 1975, 1977) were faster than theory to 1975, 1977) were faster than theory to rebuild macro from the Lucas-Sargent rebuild macro from the Lucas-Sargent “wreckage”“wreckage”
Mid 1970s, Ned Also Planted Mid 1970s, Ned Also Planted Seeds of “New Keynesian Seeds of “New Keynesian
Economics”Economics” He opened up the route to a theoretical He opened up the route to a theoretical
understanding of “staggered wage setting”understanding of “staggered wage setting” Key idea turns New Classical Mark I (and Key idea turns New Classical Mark I (and
his previous work) on its headhis previous work) on its head Once you explain why wages are sticky, Once you explain why wages are sticky,
you can no longer claim that business you can no longer claim that business cycles are due to expectational errorscycles are due to expectational errors
An exogenous constraint sets the length of An exogenous constraint sets the length of labor contractslabor contracts
They do not all expire at the same time, They do not all expire at the same time, assume they last N months, 1/N expire this assume they last N months, 1/N expire this monthmonth
Phelps-Taylor at the DawnPhelps-Taylor at the Dawnof New-Keynesian Macroof New-Keynesian Macro
They deserve joint credit with Fischer They deserve joint credit with Fischer (1977)(1977)
Muth invented rational expectations Muth invented rational expectations for micro in 1961, Lucas introduced for micro in 1961, Lucas introduced into macro in 1972-73into macro in 1972-73
Fischer, Phelps-Taylor “stole” rational Fischer, Phelps-Taylor “stole” rational expectations and showed that it was expectations and showed that it was a separate idea that could span New-a separate idea that could span New-Classical and new-Keynesian macroClassical and new-Keynesian macro
What Phelps-Taylor ShowedWhat Phelps-Taylor Showed
Two-sided lead-lag distributionTwo-sided lead-lag distributionWage changes had to depend on lags Wage changes had to depend on lags
because the price level faced by because the price level faced by today’s wage setters depends on the today’s wage setters depends on the wage contracts of the pastwage contracts of the past
Expectations matter because today’s Expectations matter because today’s wage setters have to guess about wage setters have to guess about macro conditions in the futuremacro conditions in the future
Opened the Way to a UnificationOpened the Way to a Unificationof New-Classical and New-of New-Classical and New-
KeynesianKeynesian The forward-looking element allowed a link The forward-looking element allowed a link
to Sargent’s famous “The End of Four Big to Sargent’s famous “The End of Four Big Inflations”Inflations”
When inflation is dominated by When inflation is dominated by expectations (German hyperinflation, expectations (German hyperinflation, Argentina or Brazil) staggered wage-Argentina or Brazil) staggered wage-setting can adjust rapidlysetting can adjust rapidly
When inflation is slow, staggered wage When inflation is slow, staggered wage setting is largely backward-lookingsetting is largely backward-looking
““Rational Expectations is Adaptive after Rational Expectations is Adaptive after All” (Ben Friedman, 1977)All” (Ben Friedman, 1977)
A Unified Framework BeyondA Unified Framework BeyondLucasLucas
Lucas (1972, 1973) introduced distinction Lucas (1972, 1973) introduced distinction between aggregate and local shocksbetween aggregate and local shocks
Individual suppliers assess difference Individual suppliers assess difference between local price and aggregate pricebetween local price and aggregate price
When they observe a big increase in local When they observe a big increase in local price, they assess the likelihood that the price, they assess the likelihood that the aggregate price has increasedaggregate price has increased
With US historical variances, they increase With US historical variances, they increase supply, with South American history they supply, with South American history they assume it’s aggregateassume it’s aggregate
So the slope of the P Curve is endogenous So the slope of the P Curve is endogenous to the historical variancesto the historical variances
Broaden Lucas Local and Agg Broaden Lucas Local and Agg ShocksShocks
to both Supply and Demandto both Supply and Demand Gordon JEL 1990 with reliance on Gordon JEL 1990 with reliance on
Blanchard BPEA 1987Blanchard BPEA 1987 The absence of perfect price flexibility The absence of perfect price flexibility
comes from reasons that price level does comes from reasons that price level does not “mimick” changes in nominal GDPnot “mimick” changes in nominal GDP
In a recession firms cannot afford to cut In a recession firms cannot afford to cut prices unless they know their input prices prices unless they know their input prices will fall (wages and intermediate goods)will fall (wages and intermediate goods)
Why should wages and intermediate goods Why should wages and intermediate goods prices mimick nominal GDP?prices mimick nominal GDP?
The Four-way Shock AnalysisThe Four-way Shock Analysis
Aggregate and local, supply and demandAggregate and local, supply and demandAggregate demand shocks raise output Aggregate demand shocks raise output
because prices/wages are sticky; because prices/wages are sticky; expectations matter in volatile expectations matter in volatile economies like Latin Americaeconomies like Latin America
Aggregate supply shocks with inelastic Aggregate supply shocks with inelastic price elasticity of oil/food cause price elasticity of oil/food cause recessions unless wages are perfectly recessions unless wages are perfectly flexibleflexible
The Local Part of the Four-wayThe Local Part of the Four-wayAnalysisAnalysis
Local supply shocks explain why Local supply shocks explain why firms do not immediately change firms do not immediately change price in proportion with nominal GDPprice in proportion with nominal GDPThey do not know what commodity They do not know what commodity
prices are going to doprices are going to doThey “sit by the mailbox” waiting for They “sit by the mailbox” waiting for
news about intermediate materials costsnews about intermediate materials costsLocal demand shocks mean that Local demand shocks mean that
prices do not mimick nominal GDP, prices do not mimick nominal GDP, think corn and ethanolthink corn and ethanol
Summary So Far on PhelpsSummary So Far on Phelps
He created the NRH and revolutionized macroHe created the NRH and revolutionized macro By embedding his analysis in expectational By embedding his analysis in expectational
errors, he pushed macro in the wrong directionerrors, he pushed macro in the wrong direction He rescued his contribution by developing the He rescued his contribution by developing the
model (with Taylor) of staggered wage settingmodel (with Taylor) of staggered wage setting And he helped develop modern macro by And he helped develop modern macro by
integrating the analysis of supply shocks, integrating the analysis of supply shocks, showing that the correlation of inflation and showing that the correlation of inflation and unemployment could be in any directionunemployment could be in any direction
The Island Parable and The Island Parable and Customer MarketsCustomer Markets
Like much of new-classical macro, the Like much of new-classical macro, the “island” parable makes more sense “island” parable makes more sense restated from prices to quantitiesrestated from prices to quantities
Real-world workers are not moving from Real-world workers are not moving from Detroit to Greenville SC because they Detroit to Greenville SC because they think the wage is higherthink the wage is higher
They move because they think jobs are They move because they think jobs are available in Greenville to replace their available in Greenville to replace their destroyed Detroit job as GM fails to destroyed Detroit job as GM fails to compete with Toyotacompete with Toyota
Much of Informational FrictionsMuch of Informational Frictionsin Early Phelpsian Econ Makes in Early Phelpsian Econ Makes
SenseSenseThe pathetic stories from the Great The pathetic stories from the Great
Depression of men leaving their Depression of men leaving their families and riding on boxcars in families and riding on boxcars in search of employmentsearch of employment
This had nothing to do with wages or This had nothing to do with wages or prices, it was about rationed prices, it was about rationed quantitiesquantities
Tie back to Barro-Grossman-Clower-Tie back to Barro-Grossman-Clower-PatinkinPatinkin
Customer MarketsCustomer Markets
(Phelps-Winter in the Phelps volume)(Phelps-Winter in the Phelps volume) Imperfect information keeps customers Imperfect information keeps customers
attached to existing merchants, they attached to existing merchants, they have to search to find lower prices have to search to find lower prices elsewhere and this is costlyelsewhere and this is costly
This is proposed as a source of price This is proposed as a source of price stickiness since merchants lose stickiness since merchants lose customers only gradually if their prices customers only gradually if their prices are too highare too high
The Big Payoff: OkunThe Big Payoff: Okun
Maybe Phelps thought this up first, but I associate Maybe Phelps thought this up first, but I associate with Okun the distinction between “auction with Okun the distinction between “auction markets” and “customer markets”markets” and “customer markets”
Surveyed in my JEL paper 1981Surveyed in my JEL paper 1981 ““Why are there no auctions for tunafish in the Why are there no auctions for tunafish in the
supermarket aisle?”supermarket aisle?” Dispersion of time and location of local purchasesDispersion of time and location of local purchases Phelps-Winter idea of imperfect information weakened Phelps-Winter idea of imperfect information weakened
by weekly supermarket advertising supplementsby weekly supermarket advertising supplements Also weakened by IO-reality of scale economies that give Also weakened by IO-reality of scale economies that give
customers limited choices within feasible geographical customers limited choices within feasible geographical range.range.
Combining Customer MarketsCombining Customer Marketswith the Input-Output Tablewith the Input-Output Table
Long Literature back to Berle-Means in the Long Literature back to Berle-Means in the 1930s that the degree of price flexibility 1930s that the degree of price flexibility differs across productsdiffers across products
Stylized fact: farm prices 1929-33 fell by Stylized fact: farm prices 1929-33 fell by 75%, tractor prices fell 10%75%, tractor prices fell 10%
Why? “Business Cycles and the Price of Why? “Business Cycles and the Price of Lettuce”Lettuce”
Food prices are very flexible, reflect land Food prices are very flexible, reflect land rents. Tractor prices are inflexible, rents. Tractor prices are inflexible, reflecting large labor component not just in reflecting large labor component not just in assembly of tractors but in each of the assembly of tractors but in each of the many complex componentsmany complex components
Efficiency WagesEfficiency Wages
Replaces classical equilibrium model in Replaces classical equilibrium model in which all workers earn the same wageswhich all workers earn the same wages
A true descendant of the “island” search A true descendant of the “island” search model model
Workers are constantly thinking about Workers are constantly thinking about alternativesalternatives
If “training capital” is embedded in each If “training capital” is embedded in each worker, the firm has a big incentive to worker, the firm has a big incentive to keep them from quitting, so pay them keep them from quitting, so pay them more than their “opportunity wage”more than their “opportunity wage”
What does this have to do with What does this have to do with macro?macro?
Efficiency wage story establishes a Efficiency wage story establishes a premium of actual wage over opportunity premium of actual wage over opportunity or alternative wageor alternative wage
If the alternative wage is completely If the alternative wage is completely flexible to changes in nominal GDP, then flexible to changes in nominal GDP, then the efficiency wage story has no the efficiency wage story has no consequences for business cycles.consequences for business cycles.
Viewed further from input-output 4-way Viewed further from input-output 4-way theory, efficiency wages introduce yet theory, efficiency wages introduce yet another source of frictionsanother source of frictions
What About “Structural What About “Structural Slumps”?Slumps”?
An ambitious cosmic model of the world An ambitious cosmic model of the world economyeconomy
Defining elements are the wage-setting Defining elements are the wage-setting curve and the powerful role of the real curve and the powerful role of the real interest rate in setting aggregate demandinterest rate in setting aggregate demand
How does this hold up?How does this hold up? World interest rate rose in 1981-85 with World interest rate rose in 1981-85 with
American shift to tight money/ loose fiscalAmerican shift to tight money/ loose fiscal But evolution of US and EU economies were But evolution of US and EU economies were
very different after thatvery different after that 1981-2007 big increase in EU unemployment 1981-2007 big increase in EU unemployment
rate relative to US unemployment rate, decline rate relative to US unemployment rate, decline in H/Nin H/N
Phelps Applies Structural SlumpsPhelps Applies Structural SlumpsModel to Historical EpisodesModel to Historical Episodes
Following the org of Woodford (JEL, 1994)Following the org of Woodford (JEL, 1994) The Economics of WWIIThe Economics of WWII
Phelps claims that there was an increase in the Phelps claims that there was an increase in the relative price of capital goodsrelative price of capital goods
Oh, do I know a lot about WWIIOh, do I know a lot about WWIIA controlled, rationed economy. No role for relative A controlled, rationed economy. No role for relative
prices at all since prices were controlled, both capital prices at all since prices were controlled, both capital goods and consumer goodsgoods and consumer goods
Jan 1942, production of cars = 0. INSTANTLYJan 1942, production of cars = 0. INSTANTLYThe government pushed money into corporate The government pushed money into corporate
America with only one goal – MAXIMIZE productionAmerica with only one goal – MAXIMIZE production
Further Problems with WWII Further Problems with WWII StoryStory
The central mechanism of “Structural The central mechanism of “Structural Slumps” cannot play a role in US WWIISlumps” cannot play a role in US WWII
The “Accord” between Fed and Treasury The “Accord” between Fed and Treasury maintained low nominal interest rate in maintained low nominal interest rate in WWII (until 1951)WWII (until 1951)
Price controls were effective and Price controls were effective and eliminated (measured) inflation 1942-45eliminated (measured) inflation 1942-45
Thus real interest rates were fixed during Thus real interest rates were fixed during WWII, could not have had any part in WWII, could not have had any part in allocation between capital and consumer allocation between capital and consumer goodsgoods
Forget WWII, the True Forget WWII, the True ApplicationApplication
of Phelps Theory is to Europeof Phelps Theory is to EuropeThe Facts to be ExplainedThe Facts to be Explained
The obvious facts: US unemployment The obvious facts: US unemployment corrected for the business cycle and corrected for the business cycle and supply shocks (important!) has been supply shocks (important!) has been stationary over 1960-2007stationary over 1960-2007
Europe’s (EU-15) unemployment rose Europe’s (EU-15) unemployment rose from 2% in the early 70s to ~10% in the from 2% in the early 70s to ~10% in the last decade. Why?last decade. Why?
What Happened to European What Happened to European UnemploymentUnemployment
In a striking reversal, Phelps realizes that his In a striking reversal, Phelps realizes that his 1960s natural rate approach won’t work1960s natural rate approach won’t work
The 1970-90 increase in European The 1970-90 increase in European unemployment unemployment was permanentwas permanent, no , no expectational errors will help in explaining itexpectational errors will help in explaining it
Phelps attributes it primarily to the oil shock Phelps attributes it primarily to the oil shock of the 1970s and the fiscal shock (orginating of the 1970s and the fiscal shock (orginating with Reagan) that raised the world real with Reagan) that raised the world real interest rate in the early 1980sinterest rate in the early 1980s
But This Won’t Work, Why?But This Won’t Work, Why?
European Unemployment Remained High European Unemployment Remained High Until RecentlyUntil Recently
Oil Prices in real terms collapsed in 1986. Oil Prices in real terms collapsed in 1986. Oil prices were ~$12 a barrel in early 1998Oil prices were ~$12 a barrel in early 1998
Real interest rates are worldwide and Real interest rates are worldwide and capital markets are open, why any special capital markets are open, why any special effect on Europe compared to the US?effect on Europe compared to the US?
US dollar was pushed up 1981-85 by US dollar was pushed up 1981-85 by switch in monetary-fiscal mix but then switch in monetary-fiscal mix but then collapsed back to 1981 level by 1987. collapsed back to 1981 level by 1987.
Emphasis on EU UnemploymentEmphasis on EU UnemploymentMisses the Two Big Macro Events Misses the Two Big Macro Events
Post-1980Post-1980
Decline in US Business Cycle VolatilityDecline in US Business Cycle VolatilityHundreds of papers on thisHundreds of papers on thisWas it monetary policy? Was it monetary policy? Was it reduction in shocks?Was it reduction in shocks?Of course the best paper is mine Of course the best paper is mine
2/3 decline in demand shocks, 1/3 2/3 decline in demand shocks, 1/3 supply shocks, ZERO for monetary supply shocks, ZERO for monetary policypolicy
Puzzle # 2: The Convergence Puzzle # 2: The Convergence of Inflation Ratesof Inflation Rates
Chapter 8IP Box: Inflation in Europe
-5
0
5
10
15
20
25
30
1975 1980 1985 1990 1995 2000 2005
Infl
atio
n r
ate
in p
erce
nt
UK Italy
France
US
Germany
This is Where We Come BackThis is Where We Come BackFull Circle to the Genius of NedFull Circle to the Genius of Ned
I have been skeptical about the relevance I have been skeptical about the relevance of expectations in the US macro context, of expectations in the US macro context, esp. Great Depressionesp. Great Depression
But nobody could deny the central role of But nobody could deny the central role of expectations inexpectations in The ends of Sargent’s “Four Big Inflations”The ends of Sargent’s “Four Big Inflations” The convergence of European inflation pre-The convergence of European inflation pre-
EuroEuro How to put all this together? Turn to How to put all this together? Turn to
Akerlof’s Presidential AddressAkerlof’s Presidential Address
Akerlof’s Five Neutralities that Akerlof’s Five Neutralities that Overturned Keynes, but GA Overturned Keynes, but GA
Revives ThemRevives ThemPermanent income hypothesisPermanent income hypothesisModigliani-Miller “cash flow doesn’t Modigliani-Miller “cash flow doesn’t
matter for investment”matter for investment”Natural Rate HypothesisNatural Rate HypothesisPolicy Ineffectiveness PropositionPolicy Ineffectiveness PropositionBarro-Ricardo Fiscal NeutralityBarro-Ricardo Fiscal Neutrality
How Does this Affect the PhelpsHow Does this Affect the PhelpsContributions?Contributions?
Fortunately for Ned, he is only Fortunately for Ned, he is only involved with the NRH among the involved with the NRH among the five neutralities that GA demolishesfive neutralities that GA demolishes
I don’t think the nominal wage band I don’t think the nominal wage band at zero matters except for US Great at zero matters except for US Great Depression and Japan in 1990sDepression and Japan in 1990sWhy no accelerating deflation??Why no accelerating deflation??
Ned never took seriously any of the Ned never took seriously any of the other four neutralitiesother four neutralities