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