Political Economist

(3) R.M. Brown

R.M Brown is a Professor of Theology and Ethics at the Pacific School of Religion. As a lifetime theologian and ethical philosopher, he may resolve the questions Simon had to face.

He starts his essay from the memory of a commemoration ceremony he attended in Warsaw in 1979. Even though he admits that the slogan, “never forget, never forgive” should be maintained as a maxim in most human atrocities, he also offers Nelson Mandela’s and Tomas Borge’s sublime attitudes toward their perpetrators as good examples for the possibility of opposite reasoning; in their cases, even though they are not so common, forgiveness sometimes does much more than the simple punishment can.

Based on this preliminary sketch, Professor Brown says that if he were Simon, he “would have urged the dying SS man to address his plea directly to God, and throw himself on the possibility of Divine Mercy.”(123)

This main argument on Simon’s dilemma is based on his own reflections on Elie Wiesel’s theological and ethical questions. According to Professor Brown, Elie Wiesel raised two serious questions in his novel: “Where is God in all these atrocities?” and “what is there left for us to do?”(123-24)

Brown confesses that he could not find any proper answers to these questions. Thus, the only thing he can do is to urge to follow and respect God’s rules without doubting the omnipresence of God. “And if we do so, perhaps, just perhaps, a world will begin to emerge in which we do not have to ask unanswerable questions any longer.”(124)

With respect to Professor Brown’s responses, I wonder whether it was possible for Simon to urge Karl to pray for forgiveness to his God, not to Simon, in that situation. Maybe Karl, the dying SS man, already prayed for absolution to his God. But it might not be sufficient for him to feel that he could die in peace. That was perhaps the reason why he made up his mind to confess his crimes in the face of a Jew, Simon. If that is the case, Professor Brown’s ‘humble opinion’ may not be useful answers or even advice for Simon.

(4) Robert Coles

Robert Coles is a professor of both Psychiatry and Medical Humanities and Social Ethics at Harvard University. As a scholar who has studied ordinary men’s and women’s vulnerable and fragile mentalities, he does not hesitate to recognize Simon’s consistent moral attitude toward the dying SS man.

But if he were in Simon’s shoes, he says, he “would pray for the Lord’s forgiveness” of the dying SS man, even though “he would have turned his eyes away in a tearful rage.”

The reason for this forgiveness is not because he believes that everyone is alike as a “sinner” under God, but because he knows the absolute finiteness of human beings.

This seems to me that we, as ordinary human beings with limitations, don’t have any absolute rights or authority to decide to forgive or not to forgive somebody instead of God.

At any rate, even after he uttered he would have forgiven Karl, he added that he had no “conviction of righteousness.” Robert Coles’ stumbling attitude reminds me of Simon’s silence. In the end, Robert Coles himself may not know how to deal with the dilemma.

(5) The Dalai Lama

The Dalai Lama is one of the most prestigious spiritual leaders of Buddhism not only in his own country, Tibet, but also around the world. After the Chinese government’s invasion and occupation of Tibet, he escaped to India in 1959. Since then he has continued to preach to Tibet people nonviolent and peaceful independence movement.

As a Buddhist spiritual leader, he asserts that we “should forgive persons who have committed crimes against oneself and humankind.”(129) According to him, however, this forgiveness has nothing to do with forgetting those atrocities. Instead, it is necessary not to forget in order to prevent such atrocities from reoccurring. Thus, his opinion to Simon’s dilemma is to forgive, but never forget.

The followings are the summary of various responses to Simon's dilemma. As I already posted, this essay is based on the review of the book, The Sunflower.

(1) Jean Amery

Jean Amery was born in Vienna. He is a European critic and essayist. After German’s invasion and the proclamation of the Nuremberg Laws, he fled from his native country and joined the Resistance movement in Belgium. Due to this activity, he was captured by the Gestapo and sent to concentration camps. After the liberation, he wrote a book based on his personal experiences as a Holocaust victim and survivor.

He starts his essay by expressing his best regards to Simon for his continuous investigative activities as a commission member for investigation of NAZI crimes. At the same time, Amery explains his distinctive position, as one who does not have any moral authority to judge Simon’s behaviors, as a survivor from the concentration camp. He also wants his opinion to be understood as a private one with no significant influence on others. With these preliminary introductions, Amery argues that the question of forgiveness has two different aspects in this case: a psychological one and a political aspect.

Firstly, for him, whether to forgive Karl or not was dependent on various accidental factors which might influence Simon at such particular situations. If Simon, for example, had chances to meet one of decent SS mans who treated him relatively more gently than those of other typical SS soldiers, his decision might have been different. In this way, psychologically speaking, whether Simon should forgive Karl or not does not pose any serious moral question.

Secondly, Amery also argues that forgiving or not-forgiving is quite an irrelevant question, because this question belongs to the realm of theology or morality. Thus, the question as such does not pose any serious dilemma once we reject any metaphysics of morality and religious principles.

Amery himself want to see the whole question only in this political perspective. Thus, for him, the question simply does not exist. There is no metaphysical norm or morality upon which Simon’s attitudes can be evaluated.

However, does not this argument avoid moral questions Simon wants to discuss by shifting it to another terrain? With respect to this probable doubt, Amery said “no.” As a previous Restistance activist and as a firm advocate of political justice, he recommends that we should leave Simon’s dilemma (“the moral-theological, moral-philosophical” question of forgiveness) in the hands of professional philosophers and university professors.

In this way, Amery assures Simon not to bother himself with this metaphysical question. Even if Simon forgave the dying SS man at that time, according to Amery, nobody can blame Simon.

In my opinion, however, Jean Amery’s simple solution to the problem is not sufficient for Simon’s dilemma, because Amery’s political perspective is simply to transpose the question into another terrain. It is not the solution to Simon’s moral questions but only recommendations for self-assurance.

(2) Mark Goulden

Mark Goulden was a British journalist and publisher. After introducing his moral judgement on atrocities and inhumanity, Goulden asserts that nobody has “the privilege of granting forgiveness.”

This does not mean that we should ascribe the question of forgiveness to the realm of divinity. Rather, he criticizes any attempt to close down the dialogues about forgiveness by saying that only God can forgive. Instead, he expresses his own opinion saying that “if the dead cannot forgive, neither can the living.” He goes on “How can you forgive monsters who burned people alive in public?”

With respect to Simon’s dilemma, he does not hesitate to say that, if he were Simon, “I would have silently left the deathbed having made quite certain there was now one Nazi less in the world!” even though he admits the possibility that the answer may be different from person to person.

Will Simon accept or agree with Goulden’s attitude? From a personal aspect, as Goulden agrees, there is no single answer to the question. Thus, nobody can blame Simon’s decision. From a political perspective, Simon will surely agree with Goulden’s opinions that every citizen should fight against inhumanity and brutal crimes.

* English has become one of the most dominant languages in the world. English is not only a tool for understanding different cultures but also barrier or social pressure in Korea. I wrote this essay for my own reflection and heuristic purpose. I hope that you wil have chances to think about the role of English in this society while reading this essay.

I started learning English when I became a middle school student. Since then, English used to be not a simple language but a complicated and contradictory substance; English has not only been the object of my affection but also the barrier to overcome for various purposes.

In principle, learning foreign languages is to understand different cultures. Because the language contains various aspects of its users, we can easily understand a different culture by its language. English is no exception. By learning English, it is expected that we will learn various social phenomena and the culture of English speaking countries. In this sense, English studies should be regarded as powerful tools, not goals as such, with which we can communicate with native English speakers.

However, this point seems to be frequently ignored by many school teachers as well as students most of the time. In retrospect, there has been a certain level of social pressure related with English studies in Korea. In my case, English studies have always come to me as uneasiness or stress. For example, when I entered one of the most prestigious universities in Seoul, I had to show good grades on English tests. When I was about to get a high-paying and relatively stable job, I also had to pass a very difficult English examination with a certain level of proficiency. Even when I decided to continue my post-graduate studies abroad, I had to take various standardized English tests such as TOEFL and GRE, etc. in order to show my application qualification. In this way, English has always reminded me of standardized tests and stresses.

Furthermore, I thought that English language was not only a language but also a political weapon. If there are certain types of institutionalized social pressures related to English studies, there must be good reasons for these social contradictions. In this way, I once thought that English was not a simple language containing a particular culture, but a powerful weapon for Western imperialists. I still remember my undergraduate days; wrapped up with passionate nationalist spirits, I thought that every intelligent university student should contemplate their privileged social status critically, and in doing so they should protest not only against the rationalized structural inequality in world political orders but also the English-dominant cultural realities of Korea. At that time, English language seemed to have another symbolic meaning, namely one of cultural decorations of the strongest, representing world hegemonic powers against which I had to protest.

I was not able to put aside this mistrust toward the English language even after I graduated from the university. After graduation, I worked as a book editor at a social science publishing company for 3 years. My main job was to do some social science research and translate various English books and articles into my native language. At that time, I could not think much about English. It might be because I thought of English language as a simple way of living. It is not surprising to see that something uneasy once becomes your ordinary chores, it should no longer be a trouble.

However, English language as a complicated subject-matter exerted itself when I decided to study abroad in English speaking countries. All of a sudden, I was reminded of every complicated aspect of English language. The most difficult thing that I had to overcome was that I had to answer to my various questions in my own ways: Was English a pure language? Were not there any imperialist or mystifying aspects in English? Why should I study English or why should I prepare the TOEFL and the GRE?

At any rate, I passed various standardized English test with good grades. And, fortunately, I am in New York studying what I really want to. Of course, there were so many troubles and frustrations before I came to New York. However, since I continued to study, I have tried to communicate only in English. And I have been expected to read huge volumes of articles and books written in English, to write research papers succinctly in English on time. Unnoticeably, the language has become my official means of living.

But I can’t still cease to think about the role and socio-political status of English language in this hierarchical world order. Sometimes, the language approaches me as one of the most influential imperialist weapons covered with rosy fantasy called ‘global standard.’ It is also true that sometimes English became an ambivalent complexity itself. Even though I know that the English language is as such much more practical and simpler than any other languages such as German and French, I will not stop thinking about these multi-faceted characteristics of English for the time being.

Simon Wiesenthal, The Sunflower - On the Possibilities and Limits of Forgiveness, New York: Schocken Books, 1998.

http://www.amazon.com/exec/obidos/ASIN/0805210601/qid=1121705319/sr=2-1/ref=pd_bbs_b_2_1/002-4647197-6902411

This book is based on the real experiences of the author. It is a story of a Jew (Simon) who has been forced into a concentration camp in Nazi’s era. Under the cruel surveillance, Simon and other Jewish prisoners had no other options but to comply with Nazi soldiers’ brutal maltreatments and humiliations as their common fate.

The story proceeds along with time sequences. But the plot is not chronological, because the author sometimes overlaps his past memories and episodes with the present. The title, “Sunflower” originated from Simon’s observations on a military cemetery in which each grave was surrounded by planted sunflowers. On his gaze, the flower “seemed to absorb the sunshine and draw it down into the darkness of the grounds.”(14) With the help of the flower, even the dead were receiving sun lights and messages from the living world. Even dead soldiers were blessing with living things’ commemoration! In this sense, the sunflower is not a simple flower; it represents the connections between the dead and living world; it may be used to symbolize desperate hope to survive in the camp.

However, the main theme of the book is not limited by the author’s pathetic personal experiences; the book raises significant questions related with human existence. One day, Simon was brought to a wounded SS soldier, Karl, who had murdered Jewish people in one village. Karl wants to die in peace by confessing his previous crimes to Simon. He requests Simon to forgive him.

But how can Simon forgive this SS soldier? Even though he himself is wounded seriously and dying, his colleagues are still slaughtering a lot of innocent Jewish people. Furthermore, Simon is not free from the concentration camp; he is under the persistent threats of death by the same German soldier as this wounded SS personnel. If you were in that situation, could it be possible for you to forgive him and his crimes? How and in what way? If not, how would you behave? This book poses these difficult questions.

In front of the dying SS soldier’s deathbed, the author, Simon, kept silent because he did not know how to respond to Karl’s confession and his request for forgiveness. He walked out of the hospital without answering the request. However, Simon could not easily put down the burdens Karl left on him. Thus, he asked to his closest colleague prisoners in the concentration camp.

One of his friends, Josek, who had strong religious faith, told Simon that he had no rights to forgive the dying SS soldier’s crimes on behalf of other Jews. On the other hand, Authur, a man of cynicism, did not mind the Simon’s dilemma seriously because he took it for granted that Simon did not forgive the dying SS man. Even though their responses were based on somewhat different reasons and personalities, they showed the same responses. Unfortunately, Simon could not be content with their conclusion.

However, Simon and his companions could not have enough times to discuss about and reach to any conclusion on the problem, because they are all under continuous threats of death in the camp; “it was luxury,”(75) as Authur said, for them to discuss the question of forgiveness. Someday, if they survive the camp, there will be plenty of times to discuss the question, and there may be different viewpoints on the questions, even though nobody except them can understand fully the situations where they have been forced into.

Two years later, only Simon survived the camp. Even after his closest friends were dead, he never ceased to be thinking about the question of forgiveness. One day in another Nazi concentration camp, Simon had a chance to talk about his dilemma with Bolek who had been once a priest in Poland. According to him, every religion has the same attitudes toward the question of forgiveness in principles: even though there might be some controversies whether or not someone can forgive wrongs that have been done to others, not to him or her directly, on behalf of others, if the sinner is truly repentant he or she deserves to be forgiven. “Repentance is the most important element in seeking forgiveness,” said Bolek (83).

However, his response was not enough for Simon to resolve his dilemma, even though he realized that he felt some pity for the dying SS man. Simon realized that the feeling of pity might be different from forgiveness, even though pity could be a significant step toward forgiveness. And he also cast doubt on the religious principles Bolek said. Even though true repentance may be a necessary condition for forgiveness, it is surely not sufficient because nobody can forgive crimes done to others without delegated authorities from the victims. In this respect, the dead Josek was right; Simon had no rights to forgive Karl on behalf of other victimized Jews by Karl’s bullets.

Soon after the liberation from the camp, Simon joined a commission for the investigation of Nazi crimes, “not only because it was impossible for him simply to restart his ordinary life, but also because he thought the work of commission might help him regain his faith in humanity.”(84) After years, by chances on a journey, he could remember the whole memories of sunflower which had been ingrained in his deep unconsciousness. “I remembered the soldier’s cemetery at Lemberg, the hospital and the dead SS man on whose grave a sunflower would now be growing…”(84)

One day in the summer of 1946 Simon took a chance to visit to Stuttgart where the dead SS man was born and raised. He decides to visit to Karl’s family. “I wanted to see the SS man’s mother. If I talked with her, perhaps it would give me a clear picture of his personality. It was not curiosity that inspired me but a vague feeling of duty...and perhaps the hope of exorcizing forever one of the most unpleasant experiences of my life.” (84-85)

However, once he met Karl’s mother he realized that her husband was dead as his son was during the war. Even though Simon wanted to talk with Karl’s mother to confirm whether what Karl told him about his childhood and family was true or not, and by doing so, Simon secretly hoped that he might be able to be free from the moral dilemma Karl had left on him, he was not able to find proper ways of talking about the dead Karl’s story with Karl’s mother. Instead, Simon found that he had no other options but to be listening to this grief-stricken widow’s memories of good son. She was living on and “only for the memories of her husband and her son.”(89)

Contrary to his original secret hope – “But was I not secretly hoping that I might hear something that contradicted it [what Karl told me]?,” Karl, the dying SS man was sincere in his death chamber. What Karl told him was true: Karl was such a good boy in his family; he was influenced by religion and faithful to God when he was a child; but one day he joined the Hitler Youth. After the war begins, he volunteered as the SS military personnel. From then on, he became a beast-like murderer. Finally, on his death chamber, Karl wanted to confess his crimes that he committed against innocent Jewish people and to die in peace through repentance.

Thus, unlike his expectation, Simon found that “the solution to his problem was not a single step nearer…” (94) Rather, while listening to Karl’s mother, her innocent memories of good son and family, Simon had to contemplate another uneasy question which was related to the conditions and the possibilities of collective guilt. As Simon repeatedly reminds us, Hitler and the Nazis seized the political power not by the threats of gun and knife but by ordinary German’s political approval through representative election. If ordinary German citizens protested against their government, or at least if they did not approve the legitimacy of the regime, was it possible for a handful of Nazi military soldiers to commit genocides? “Accumulation of mistrust” and “fears” cannot be an excuse at all. Then who are responsible for war crimes against the Jews? Are only military soldiers to be blamed for?

Instead of relieving his heavy burden from his shoulders, he was reflecting that “there were millions of such families anxious only for peace and quiet in their own little nests. These were the mounting blocks by which the criminals climbed to power and kept it.”(91) More precisely, he says, “even if he [or she] has no personal guilt, he [or she] must share the shame of it. As a member of a guilty nation [community or country,] he cannot simply walk away like a passenger leaving a tramcar, whenever he chooses. It is the duty of [nations or countries] to find out who was guilty. And the non-guilty must dissociate themselves publicly from the guilty.”(93)

Simon did not tell Karl’s mother about her son’s crimes. He, once again, kept silent. He left “without diminishing in any way the poor woman’s last surviving consolations – faith in the goodness of her son.”(94) Perhaps, it might be better for him to tell Karl’s mother the truth of her son, because “perhaps her tears might help to wash away some of the misery of the world.” (94) But, perhaps not.

In the end, Simon confesses to us that he still does not know how to behave under such circumstances. He still does not know whether his silence was right or not, whether his passive response can be justifiable or not. However, instead of carrying this profound moral question alone, he seems to decide to challenge the conscience of broader audiences by way of writing. That may be the reason why this book ends with the same question, but shared with readers, “What would I have done?” if I were Simon.

R. Heilbroner & L. Throw, Economics Explained - Everything You need to know about how the economy works and where it's going, New York: Simon & Schuster(Touchstone)

The Interpretations of the Phillips Curve and their Policy Implications

 1. Introduction

A.W. Phillips estimated the relationship between the change of nominal wage rate and the change of the rate of unemployment based on empirical evidences of the U.K from 1861 to 1957 in 1958. He found that there had been a negative relation between unemployment rates and the rate of the change of money wages. Since its appearance, the Phillips Curve has been considered one of the most fundamental frameworks in analyzing the inflation and (un-)employment policy in macroeconomics (Blanchard 2002: 149).

In this context, it is no surprise to see that various macroeconomists have interpreted the implications of the Phillips Curve in their own right: The Phillips Curve has played a role of the most controversial theoretical terrains in which different macroeconomic theories have been developed. The history of the interpretations of the Phillips Curve can be traced as following steps: firstly, along with Phillips’ original estimation, R.G. Lipsey (1960) provided microeconomic foundations for later interpretations. At the same time, P.A. Samuelson and R.M. Solow (1960) replicated Phillips’ observations for the U.S, but in slightly different ways. Second stage was dominated by the ‘natural rate of unemployment’ hypothesis based on the question of long term stability of the Phillips Curve. M. Friedman (1968) and E. S. Phelps (1968; 1969) criticized the Phillips Curve on the ground that it did not consider the role of inflationary expectations and thus failed to analyze the probable shift of the curve. The third stage of the development is characterized by rational expectations school’s critiques of previous understandings of the Phillips Curve (Frisch 1983: 30).

In this essay, we will trace this history of the interpretations of the Phillips Curve. While doing so, I will analyze characteristic features of each stage of interpretations along with their resultant policy implications.

2. The Historical Interpretations of the Phillips Curve

(1) The Original Phillips Curve and Lipsey’s Micro-foundation

In his 1958 article, Phillips tested the hypothesis that the price of labor services will rise when the demand for labor is high relatively to the supply of it like any other commodities. By the same reasoning, the rate of the change of nominal wages will also be determined by the rate of the change of demand for labor, namely the unemployment.

He argued on the basis of empirical data for the UK between 1861 and 1957 that there had been “a nonlinear, negative correlation between the change in money wages and the rate of change of unemployment” during this period except certain periods of rapid rises in import prices (Phillips 1958: 283; 284). Here, the meaning of ‘nonlinear correlation’ between two variables can be easily understood when we consider the situations where the rate of the change of nominal wages is either above or below the average at a given unemployment rate due to the decreasing or increasing demand for labor which is in turn determined by economic boom and recession – business cycle (Ibid., 290).

However, Phillips himself did not explain much the reasons why this ‘nonlinear’ relation had occurred during the periods of observations. He just mentioned the role of employers’ competitive bidding for hiring laborers and certain level of time lags. According to Lipsey, Phillips had in mind that “there would be more competitive bidding when the rate of the change of unemployment is negative than when it is positive.” This is simply because in the former case every other employer also wants to hire laborers, while in the latter case every other employer will dismiss laborers.

Another explanation is closely related to the effect of expectation. When the rate of the change of unemployment is negative, some employers may decide to pay more money wages than the rate is positive. And employers’ wage determination depends not only on the present need but also on what they expect to need in the future (Lipsey 1960: 21-21). If this is the case, the actual value for the rate of the change of nominal wage tends to be larger than the average when the unemployment rate is falling, and smaller than the average when the unemployment rate is rising.

Finally, even though Phillips admits that the third factor, namely the rate of the change of retail prices may also influence the change of nominal wage rates, he argues that this cost of living adjustment has “little or no effect on the rate of change of money wages except at times when retail prices are increased by a very rapid rise in import prices.” (Phillips 1958: 283-84; 285; 293; 296-97)

However, contrast to Phillips’ argument, the cost of living adjustment had had significant effects on the change of money wages, once it affected the change of real wages. As Lipsey already pointed out, the change of the cost of living caused “nominal wages to rise by more than they otherwise would have done” during the period of observations (Lipsey 1960: 8; 10). Furthermore, the change of retail prices can be an alternative explanatory variable to the level of unemployment and the change of the rate of unemployment (Ibid., 11; 12). If this is the case, the general relation among the change of (the rate of) nominal wages, the level and the change of unemployment rate and the retail price level (the cost of living) is yet to be analyzed.

At any rate, Phillips’ argument was not theoretical but only empirical observation. He did not develop any inflation theory or labor market model based on his ‘tentative’ conclusions. It was Lipsey who paved the foundations for later theoretical interpretations of the Phillips Curve.

Lipsey provided labor market model while confirming the negative relationship between the rates of the change of nominal wage on the one hand and the level of unemployment and its rates of change on the other in his 1960 article. In order to analyze this relation with systematic model, he assumes at the outset that there is only one single labor market in which demand for and supply of labor are adjusting to each other through the (wage) price changes. In this static system, both the equilibrium wage and employment are determined by the equality of demand for labor and supply of labor. At this steady state, the rate of the change in nominal wages is assumed to be zero. In other words, there is no change in the rates of nominal wage at this static situation.

However, if there is excess demand for labor in this labor market, this will lead nominal wages to rise. To use Lipsey’s term, the rate of change in the wage (dW/W) is determined by the difference between demand and supply of labor (Ld-Ls/Ls) through ‘the wage adjustment mechanism’ (Ibid., 13). The more the demand for labor exceeds the supply of labor, the faster wage rates will increase. If the demand and supply of labor are equal, then there will be no change in money wage rates. Thus, the wage adjustment function is dW/W = α(Ld-Ls/ Ls) where α captures the strength of the effect of excess demand for labor.

Furthermore, Lipsey established a negative correlation between the excess demand for labor (Ld-Ls/ Ls) and the rate of unemployment (U). He argues that an increase in excess demand for labor would decrease unemployment rate. However, even though there is high excess demand for labor, the unemployment rate can not be equal to or below zero (Ibid., 1960: 14-15).

Based on these two assumptions, he constructs the original Phillips Curve by combining the wage adjustment function with the unemployment rate directly. If there is positive relation between the change of the rate of nominal wage and the rate of excess demand for labor, we can easily conclude that the rate of change of money wage can be explained by excess demand for labor in the market. However, because excess demand for labor is not directly observable in the labor market, we should estimate this demand by looking at the level and rate of unemployment at given conditions.[1]

In this way, Lipsey constructed a stable negative relationship between the rate of the change of money wages and the unemployment, which the original Phillips Curve represented. All of this logical procedure can be illustrated as in the following figure (Ibid., 14; Frisch 1983: 37-40).

From this analysis, Lipsey draws some provisional conclusions: firstly even though the relationship between the rate of the change in nominal wage and unemployment rate is simply negatively related with each other, “the demand and/or supply curves might shift over time in such a way as to increase the disequilibrium in spite of the increase in nominal wage rate.” (Ibid., 16) Secondly, this model itself does not provide us with enough explanations of the real causes of the disequilibrium frequently occurred in the relationship between money wage change and excess demand of labor. Thirdly, this analysis does not tell us much about the influence of trade unions on the labor market wage adjustment processes (Ibid., 17).

He also derives some macro level implications from this analysis of a single labor market model: He argues that it is necessary to know not only the aggregate level of unemployment but also its distribution between various markets of the economy in order to predict the rate of change of nominal wage. Furthermore, because the aggregate analysis tends to overstate or understate the wage rate and unemployment rate of individual markets, it is necessary to consider various deviations from its macro level average (Ibid., 19).

With respect to the implications for the government policy, however, Lipsey warns that the estimated value can be shifted once we include additional variables and/or exclude particular years of observations. In other words, the shape of the curve is subject to change due to the time interval and other variables. Secondly, the rate of the change of nominal wages may not explained by the level of unemployment especially when the unemployment rate has remained unchanged for a long time. In other words, at a given unemployment rate, the causes of the change of nominal wages rate should be explained by other variables. Finally, we also have to estimate the relation between the change of nominal wage rate and the change of prices. Thus, without sufficient evidences and empirical analysis, it would be dangerous to argue as if the price were sorely determined by the change of wage rates (Ibid., 30-31).

(2) Samuelson and Solow’s Application of the Phillips Curve to the U.S Economy

In their 1960 article, Samuelson and Solow replicated the same negative relation between the increase in hourly earning and unemployment rate for the US based on empirical data from 1900 to 1960. Even though the curve shifted upward more than the case of the UK, this higher level can be easily attributed to different effects of the degree of trade unionism and/or administered wages. Compared to the UK, U.S Phillips Curve showed more ‘downward inflexibility.’ But this difference was also considered to be the results of the U.S fractioned and relatively more imperfect labor market system. In this way, they argue, the same negative relationship between the increase in wage and unemployment rate can be established (Samuelson & Solow 1960: 190).

Based on this empirical test, Samuelson and Solow went one step further: They modified their US type Phillips Curve into the relation between average price rise per annum and unemployment rate, and then concluded that policy makers should choose a certain level from “the menu of choice between different degrees of unemployment and price stability” (Ibid., 192).[2] In addition, they argued that the government should introduce ‘institutional reform policy’ in order to lessen “the degree of disharmony between full employment and price stability.” In other words, the government can deter the inflationary effects of the wage rises by increasing geographical and industrial labor mobility and improving the flow of information in the labor market (Ibid., 190; 194).

This modification can be easily understood, once we formulate some basic equations. The price level (P_t) can be denoted by P_t = P_t^e(1+μ)F(u, z) where P_t^e represents the expected price level, μ markup of the firms, and F(u, z) captures the effects of unemployment rate (u) and of the other factors (z) which affect wage determinations. Given the effects of the other factors, we can transform F(u_t, z) to be equal to 1 – αu_t + z. Replacing in the earlier equation, we can get P_t = P_t^e (1+μ)(1– αu_t + z). From this, we can also derive the following equation: π_t = π_t^e + (μ+ z) – αu_t where π_t denotes inflation rate which is defined as the rate of change of price from last year to this year at a given time, and π_t^e denotes expected inflation rate of given time (Blanchard 2002: 150-51). If this equation is correct, the rate of the change of price is considered to be determined by the expectation of inflation plus firms’ markups and unemployment rate. The lower the unemployment rate, the higher the inflation rate will be, given the expectation of price and other variables remain constant. In other words, the higher the nominal wage, the higher the inflation.

To examine the Samuelson and Solow model from this perspective, Samuelson and Solow can be considered to modify the relation between the rate of the change of nominal wage on the one hand and the level of unemployment and its rate of change on the other hand into the simple relation between inflation rate and unemployment rate, assuming that expectations of inflation (π_t^e) will be equal to zero. Secondly, they are also considered to argue that the government should adopt certain ‘institutional reform policy’ in order to reduce the effects of ‘administered wage,’ ‘trade union density,’ etc., which might contribute to maintain ‘downward inflexibility of the Phillips Curve’ and thus reinforce the inflationary pressure. Finally, from policy makers’ point of view, their model provides them with policy menu for certain level of inflation and unemployment rate. If there is excessively high unemployment, policy maker can attempt to reduce it by government’s fiscal deficit or expansionary monetary policy.

(3) Natural Rate of Unemployment Hypothesis and the Expectations-Augmented Phillips Curve

The main argument of the Phillips-Lipsey model was that the change of wage rates could be explained by excess demand or supply of labor in the market. Thus unemployment rate can be interpreted as an indicator of the level of excess demand or supply of labor. Another implicit idea of the original Phillips Curve was that this negative correlation between nominal wage rate change and unemployment rate would remain stable in the long period of time.

However, Phillips and Lipsey did not delve into the possibility of the shift or augmentation of this curve due to the change of economic agents’ expectations. Both Friedman (1968) and Phelps (1968; 1969) introduced the distinction between short term and long term perspective, and then argued that in the long run ‘expectations (anticipations) for the future inflation’ would affect both employers and laborers to bid higher nominal wages, thereby augmenting the Phillips Curve. Thus, with respect to the government’ economic policy, the trade-off between inflation and unemployment would no longer hold.

While Friedman developed this idea of ‘expectations-augmented Phillips Curve’ in the analysis of the role of workers’ expectations for future inflation, Phelps clarified the same notion on the labor demand side. In this section, I will examine both demand and supply side explanations of the expectations-augmented Phillips Curve. Let us start from Phelps’ argument.

Phelps assumes that products and labor markets are perfect except for incomplete information flows in the labor market. His famous ‘isolated island parable’ shows how both employers and employees search employments available in the situation of ‘imperfect information about their availabilities.’ This situation gives rise to ‘search unemployment’ or ‘wait unemployment’, as workers turn down or leave their previous jobs in attempts to search for better possibilities of being paid, and as employers delay hiring decisions in order to improve their knowledge of the labor market situations (Phelps 1968: 683-86; 1969: 149-50).

Together with this labor supply side’s imperfectly informed behaviors, Phelps introduces another assumption that the cost of an employer’s recruitment increases over time. Given constant differentials between the firm’s wage rate and the wage rates paid by other firms, sudden decreases in unemployment rate will tend to increase employees’ quit rate in the firm. Facing this situation, the firm has to decide to either reduce previous output level or hire new employees. However, if additional recruitment expenditures are larger than that of differential between the wage it pays and wages paid by other competing firms, the firms will choose to raise wage rates as an alternative to the increasing marginal cost of recruitment (Phelps 1968: 686-97).

This modified excess-demand model (what he calls ‘generalized excess-demand model’) yields an inverse, augmented non-linear relationship between the change of employment rates and the rate of the change of wages and/or prices as in the case of the Phillips Curve: If there is higher rate of employment, the firms will experience higher vacancy rates. In this situation, the firms tend to raise its relative wage rates compared to other firms in order to prevent abrupt reduction in the output from occurring. In this way, as employment rate increases and the vacancy rates of the firm increases, the change of wage rates increases at a greater proportion than otherwise it would be.

Furthermore, the firm will also have to forecast wage changes elsewhere in order to estimate the employment effects of its own wage rate determination. This means that firms’ wage decisions depends not only what they think other firms do today but also what they expect other firms will do in the future. In other words, firms’ actual wage rates will be determined by the expected rate of wage change plus relative wage differential paid by the firm under stationary wage expectation. If this is the case, under imperfect information market situations, adaptive expectation for the future increase in wages and prices will lead to unstable, explosive hyperinflation (Ibid., 697-706). In this way, Phelps incorporated the role of expectations in his demand side wage decision model.[3]

While Phelps examined the firms’ wage bidding activities by firms’ dynamic profit optimization model under imperfect information, Friedman paid attention to the role of employees’ adaptive expectations. In his inaugural address of the president of the American Economic Association, Friedman argues that the government’s monetary policy can not affect interest rate in the long run. Even though the initial increase in the quantity of money will lower interest rate temporarily, this policy will also boost the increase in spending and thus raise general price level, which in turn reduce the real quantity of money. In these circumstances, if the government attempts to keep monetary expansion, economic agents will expect prices to continue to rise in the near future (Friedman 1968: 5-7).

By the same token, Friedman argues that the government fiscal and monetary policy can not reduce unemployment rate permanently. He argues that there is always some level of unemployment which is consistent with equilibrium condition. In other words, at a given condition there is ‘natural rate of unemployment’ which reflects the current ‘degree of market imperfection,’ ‘stochastic variability’ in demand and supplies of labor, ‘the cost of gathering information’ about jobs and labor availabilities, ‘the cost of mobility,’ etc. (Ibid., 7-8).

From this natural rate of unemployment hypothesis, if the government adopts monetary policy in an attempt to reduce the actual unemployment rate relatively below the natural rate, this monetary expansion will generate overall increases in prices level. Even though the initial money growth may raise aggregate output and employment level temporarily, economic agents will try to retrieve their losses of real income based on their adaptive expectation of future inflation. In this way, the higher rate of money growth will induce nominal wages to rise, and this will in turn reverse the decline in unemployment level to its former natural rate. Thus, the government’s expansionary monetary policy and artificial employment policy form a vicious circle leading to an accelerating inflation (Ibid., 9-10).

This critique and argument can be also easily understood if we use algebraic equations developed in previous section. As we already noted, the Phillips Curve was derived from the assumption that expectation of inflation was equal to zero: from the original equation, π_t = π_t^e + (μ+z) – αu_t, π_t^e = 0. Thus, π_t = (μ+z) – αu_t.  However, if expectation of inflation is not equal to zero, what will happen to the original Phillips Curve? Let’s assume that expectation of next year’s inflation is determined by this year’s actual inflation, then π_t^e = θπ_t-1 where θ captures the effects of this year’s inflation on next year’s expected inflation rate. In replacing this expectation into the original equation, we can obtain π_t = θπ_t-1 + (μ+z) – αu_t.

From this equation, if the effect of this year’s inflation on next year’s expected inflation rate is equal to zero, we can say that inflation is negatively related with unemployment rate. And if other things remain the same, next year’s inflation will sorely depend on unemployment rate. If the effect of this year’s inflation on next year’s inflation rate is larger than zero, then we can predict that next year’s inflation will depend not only on unemployment rate but also on this year’s actual inflation rate. Finally, if θ is equal to 1, this equation can be denoted by π_t – π_t-1 = (μ+ z) – αu_t. In other words, unemployment rate affects not the inflation rate itself, but the change in the inflation rate. If this equation holds, in other words, expectation of inflation is based on previous year’s actual inflation (Friedman’s adaptive expectation), the rate of change in the inflation will increase if unemployment rate is reduced by the government monetary expansion (Blanchard 2002: 150-54).

Friedman’s concept of natural rate of unemployment can also be derived from this equation. The natural rate of unemployment is the unemployment rate where the actual inflation rate is equal to the expected inflation rate from this equation. In other words, from π_t = π_t^e + (μ+z) – αu_t, π_t = π_t^e = 0. Thus, 0 = (μ+z) – αu. If we solve for the unemployment rate, this will give u_n = (μ+z) / α. Replacing (μ+z) by αu_n in the original equation, π_t = π_t^e – α(u_t – u_n) or π_t – π_t-1 = – α(u_t – u_n). In other words, as Friedman said, the change in inflation rate is determined by the difference between the actual unemployment rate and natural unemployment rates. If the government attempt to reduce the actual unemployment rate relatively below the natural rate of unemployment rate, this policy will lead to the increase in inflation rates (Ibid., 154-56).

For our present purpose, it is necessary to pay attention to his critique of the Phillips Curve and its policy implications. Based on the notion of natural rate of unemployment, Friedman argues that even though Phillips’ analysis of the relation between unemployment and wage change is one of the greatest contributions, he fails to distinguish nominal wages from real wages. In other words, Phillips assumed that “nominal prices would be stable and expectation would remain unshaken and immutable” whatever happened to actual prices and wages (Friedman 1968: 8). Thus, for Friedman, the trade-off between inflation and unemployment is always a temporary option. “There is no permanent trade-off” between them (Ibid., 11)

In the end, Friedman asserted that traditional role of the government monetary policy should be revised. If the government can not control real interest rate, natural rate of unemployment, the real quantity of money, then monetary policy should focus instead on ‘the overall stability’ of economic system: monetary policy should be utilized to prevent money itself from being a major source of economic disturbance; It should provide ‘stable backgrounds for the overall economy,’ contributing to ‘offsetting major disturbances arising from other sources in the economic system’ (Ibid., 11-17).

(4) Rational Expectations Models and the Phillips Curve

The third stage in the interpretation of the Phillips Curve is the critique by rational expectations school. Lucas (1972a; 1972b) and Sargent (& Wallace 1973; Sargent 1973) went one step further from adaptive expectation model, and challenged the natural rate of unemployment hypothesis by introducing rational expectations agents model. They argued that inflationary expectations are formed by ‘rational’ economic agents who are taking into account all the information available about the economy. Based on this rational expectation agents model, Lucas and Sargent argued that the Phillips type trade-off would not exist even in the short run.

At first, Lucas was working on what he calls ‘expectation theory of the Phillips Curve,’ testing the presence of the short run Phillips relation based on the U.S time-series data for 1904-65. He concluded that the Phillips Curve existed at certain periods of time, but was a short run phenomenon in the U.S. Thus, without identifying other variables which might affect the shifts of the curve, the Phillips Curve should not be used as a foundation for policy decision (Lucas & Rapping 1969).

However, in his 1972 article “Expectations and the Neutrality of Money,” Lucas turned his focuses onto imperfect markets disturbances and economic agents’ hedging behaviors under inflationary situations. After modifying the original Phillips Curve into “the systematic relationship between the rate of change in nominal prices and the level of real output”(Lucas 1972a: 66), he tried to explain the reasons why real output increases in accordance with the increase in the quantity of money even when economic agents are assumed to be rational. If economic agents have rational expectations scheme, and the money is neutral in Friedman’s sense, how can we relate the increase in the supply of money with the real output increase? (Ibid., 66-67)

Regarding this question, he ascribed a main source of the existence of the Phillips relation to imperfect information flow in the market: if economic agents are free of money illusion, monetary expansion would have no real effects on aggregate output increase. However, economic agents’ information can only be conveyed to them by market price movements at certain situations. Thus, economic agents may not distinguish the real economic situations from monetary disturbances (Ibid., 84).

Lucas deals with this problem more explicitly in his attempt to testing the natural rate hypothesis. To summarize his arguments for our present purpose, ① neither adaptive expectations nor rational expectations agents model lead to the natural rate of unemployment hypothesis. ② even if we admit the existence of the natural rate of unemployment, there is no room for empirical inflation-real output ‘trade-off.’ The Phillips relation is a historical phenomena originated mainly from imperfect information in the market. In this way, Lucas historicized the existence of the Phillips relation, ascribing it to imperfect information constraints in the market (Lucas 1972b: 90-91; 100).

While Lucas developed his criticism of the Phillips Curve based on microeconomic models, Sargent started from the analysis of Phillips Cagan’s hyperinflation model. Cagan’s model was originally designed to analyze the dynamics of the government’s monetary policy and its effects on hyperinflation. In his model, once the government resorts to creation of money in order to finance its expenditures, this monetary response affects the overall price level and this in turn forms the public’s expected rate of inflation (Sargent & Wallace 1973: 333).

Here Sargent introduces the assumption of the public’s rational expectations for the future inflation in this model.[4] According to him, current rate of inflation is influenced by the current forecast of inflation for next period. But next period’s inflation rate also depends on the next period’s expectation of inflation two period hence. In this way, the public’s rational forecasting scheme projects their expectations for future inflation farther into the future. Given this rational formation of expectations, if the public forms its expectations of subsequent growth of money supply, from between the public’s expectation and the government money creation emerges a vicious circle (feedback) infinitely (Ibid., 1973: 331-33; 336-37; 349-50).

In this way, once the government starts to intervene in the economy through its expansionary monetary policy, the economic agents will raise their inflationary expectations, and this feedback process will in turn shift the Phillips Curve far away. If this is the case, there will be no room for the government to choose certain tolerable price stability at the expense of unemployment. As soon as the government decides to adopt expansionary monetary policy, the trade-off between unemployment and inflation will disappear.

3. Conclusion

Until now, we have followed the history of various interpretations of the Phillips Curve from Lipsey’s micro foundation to rational expectation school’s radical critiques. From historical perspective, the Phillips Curve has been a terrain in which various macroeconomic theorists assert the validity of their arguments.

When Phillips drew downward-slopping curve between the change of the rate of nominal wages and the rate of unemployment, he did not explain macroeconomic meanings of his observations. In addition, even though he mentioned the possibility of the firms’ competitive bidding for money wages, he did not explain systematically the underlying motives behind the firms’ activities. Finally, by excluding the effects of the cost of living on nominal wage adjustment, he left the relation between nominal wages and overall price level untouched.

While Phillips stayed on his empirical observations, Lipsey tried to provide initial labor market model in which excess demand for labor contributed to generate the non-linear relationship between the changes of the rate of nominal wages and the rate of unemployment. However, he was still warning against any hasty policy derivation from the original Phillips Curve, because he thought that there remained a lot of variables unexplored and relations among variables being excluded.

It was Samuelson and Solow who modified the original Phillips relation into the relationship between ‘inflation rate’ and ‘unemployment rate.’ With this modification, they were able to recognize the presence of the same curve in the U.S economy, and to argue that the government should choose trade-off between two dualistic values. From then on, the Phillips Curve had been widely understood as an omnipotent guide for (anti-)inflation policy and exploited by myopic post-Keynesian macroeconomic policy.

Those who criticized this (mis-)understanding was not from ‘classical Marxian’ or ‘Keynesian’ economists who had traditionally advocated the class interest of laborers but from one group of radical neoclassical economists – ‘monetarist’ equipped with the Ricardian quantity theory of money. Both Friedman and Phelps argued that policy trade-off between inflation and unemployment was only a temporary phenomenon. Considering adaptive expectations of the economic agents, the government’s monetary expansion would only lead to inflation. Thus, the role of the government should be restricted under the principles of overall price stability of economic system.

While both Friedman and Phelps focused on the role of economic agents’ adaptive expectations for future inflation, Lucas and Sargent went one step further in order to solve the probable ‘paradox’ of the assumption of adaptive expectations. By assuming the ‘rationality’ of economic agents’ expectations – information process schemes based on the availability of economic variables, they argued that economists did not have to resort to ‘natural rate of unemployment hypothesis’ in order to reject the government monetary intervention. From now on, any types of the government’s monetary intervention would be anticipated and analyzed by rational economic agents’ information process scheme, thus economists would no longer have to historicize the Phillips relation: the trade-off between inflation and unemployment would no longer exist even in the short run.

References

Blanchard, O. 2002. Macroeconomics, New Jersey: Prentice-Hall, pp.149-163.

Friedman, M. 1968. “The Role of Monetary Policy,” The American Economic Review, Vol. 58, No.1 (Mar., 1968), pp.1-17.

Frisch, H. 1983. Theories of Inflation. Cambridge: Cambridge University Press. pp. 30-89.

Lipsey, R. G. 1960. “The Relation between Unemployment and the Rate of Changes of Money Wage Rates in the United Kingdom, 1862-1957: A Further Analysis,” Economica, New Series, Vol. 27, No. 105 (Feb., 1960), pp.1-31

Lipsey, R.G. 1974. “The Micro Theory of the Phillips Curve Reconsidered: A Reply to Holmes and Smyth,” Economica, New Series, Vol. 41, No. 161 (Feb., 1974), pp.62-70.

Lucas, R.E. & Rapping, L.A. 1969. “Price Expectations and the Phillips Curve,” The American Economic Review, Vol. 59, No. 3 (Jun., 1969), pp.342-350.

Lucas, R.E. 1972a. “Expectations and the Neutrality of Money,” Journal of Economic Theory, Vol. 4 (Apr., 1972), pp.103-124. (reprinted in Lucas, R.E. 1982. Studies in Business-Cycle Theory, Cambridge: MIT Press, pp.66-89.)

-------------. 1972b. “Econometric Testing of the Natural Rate Hypothesis,” The Econometrics of Price Determination Conference, ed., by Otto Eckstein, Washington, D.C.: Board of Governors of the Federal Reserve System, pp.50-59. (reprinted in Lucas, R.E. 1982. Studies in Business-Cycle Theory, Cambridge: MIT Press, pp.90-103.)

Phelps, E.S. 1968. “Money-Wage Dynamics and Labor Market Equilibrium,” Journal of Political Economy, Vol. 76, No. 4 (Jul.-Aug., 1968), pp.678-711.

--------------. 1969. “The New Microeconomics in Inflation and Employment Theory,” American Economic Review, Vol. 59, No.2, Papers and Proceedings of the 81^st Annual Meeting of the American Economic Association, (May, 1969), pp.147-160.

Phillips. A.W. 1958. “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957,” Economica, New Series, Vol. 25, No. 100 (Nov., 1958), pp.283-299.

Rees, A. 1970. “The Phillips Curve as a Menu for Policy Change,” Economica, New Series, Vol. 37, No. 147 (Aug., 1970), pp.227-238.

Samuelson, P.A & Solow, R.M. 1960. “Problem of Achieving and Maintaining a Stable Price Level – Analytical Aspects of Anti-Inflation Policy,” The American Economic Review, Vol. 50, No.2, Papers and Proceedings of the 72^nd Annual Meetings of the American Economic Association (May 1960), pp.177-194.

Sargent, T.J. 1973. “Rational Expectations, the Real Rate of Interest, and the Natural Rate of Unemployment,” Brookings Papers on Economic Activity, Vol.1973, No. 2, pp.429-480.

Sargent, T.J. & Wallace, N. 1973. “Rational Expectations and the Dynamics of Hyperinflation,” International Economic Review, Vol. 14, No. 2 (Jun., 1973), pp.328-350.

Smyth, D.J. & Holmes, J.M. 1970. “The Relation between Unemployment and Excess Demand for Labor: An Examination of the Theory of the Phillips curve,” Economica, New Series, Vol. 37, No. 147 (Aug., 1970), pp.311-315.

Smyth, D.J. 1971. “Unemployment and Inflation: A Cross-Country Analysis of the Phillips Curve,” The American Economic Review, Vol. 61, No. 3 (Jun., 1971), pp.426-429.

The following article is a presentation paper addressed at the International Research Forum on Monetary Policy Conference, Frankfurt am Main, Germany, May 20 2005. It is also available on the website at http://www.federalreserve.gov/. It seems to be very interesting to see how FRB staffs forecast inflation and conduct monetary policy based on Expectations-Augmented inflation framework which was proposed by M. Friedman and E. Phelps in mid 1960s.

Remarks by Governor Donald L. Kohn
To the International Research Forum on Monetary Policy Conference, Frankfurt am Main, Germany, May 20, 2005

Modeling Inflation: A Policymaker’s Perspective

Nothing is more important to the conduct of monetary policy than understanding and predicting inflation. Price stability is our responsibility as central banks--it is how, in the long run, we contribute to society's welfare. Achieving and maintaining price stability will be more efficient and effective the better we understand the causes of inflation and the dynamics of how it evolves. ¹

I think central bankers are asking more of inflation analysis these days. In the United States, our attention was focused for many years on containing and then reducing inflation. The risks and rewards were one-sided, and policymakers were mostly interested in whether inflation would rise. Now that we are in the neighborhood of price stability, we can be faced with looking at the possibility that inflation will fall too low as well as rise too high. Moreover, so long as inflation expectations are well anchored, we can tolerate limited changes in inflation, but we need to know that a rise or fall is not the beginning of a more extended trend. Consequently, we focus closely on the reasons for any changes in inflation and their implications for the outlook.

Of course, I have always known how important the analysis and forecasting of inflation was for monetary policy, but I must admit that as someone who now has to go on record with a vote on the basis of some notion of the future course of inflation, the exercise has taken on added meaning. I thought I might take advantage of this captive audience of researchers on central bank policies to ruminate a bit on the evolution of inflation modeling and suggest areas for further research. I know that European central banks have been in the forefront of recent efforts to improve our understanding of some key issues in this area, but I will focus on our practices in the United States.

The Stability of the Basic Framework
I find it remarkable how fundamentally stable our basic framework for analyzing inflation has remained over the past thirty-five years or so: That basic framework is essentially the expectations-augmented Phillips curve introduced by Milton Friedman and Edmund Phelps in the late 1960s.²

One of the key assumptions underlying this basic framework is the temporary rigidity of wages and prices. It is because of these nominal rigidities that monetary shocks have real effects: In the well-known litany, wages and prices do not change immediately in response to a positive monetary surprise, so real interest rates fall, and spending is stimulated. But higher demand cannot be met without pushing firms up their marginal cost curves as they compete for scarce labor and other resources. As opportunities to raise prices present themselves, firms take them to better align prices with costs. That process may be gradual, because firms' competitors may not be raising their prices at the same time.

It is easy to see in this tale the central mechanism of the Phillips curve. What is missing from the story, though, is that seminal feature of Friedman and Phelps's framework, namely, expectations. Expectations are a key part of the framework because wages and prices will be set for some time, and so it is important for workers and firms to consider the economic conditions expected to prevail during the period that the wages and prices are fixed. If inflation is anticipated over the period ahead, wages and prices will be set commensurately higher as workers and firms strive to protect themselves against the erosion of their purchasing power.

As Friedman and Phelps emphasized, these efforts to protect against the erosion of purchasing power by inflation will mean that an ongoing and fully anticipated inflation will, to a first approximation, have no effect on the level of resource utilization; the outcome of the economy will be whatever the real forces at work dictate. Friedman called the unemployment rate determined by such real factors the natural rate of unemployment. An important implication of the expectations-augmented Phillips curve is that any attempt to use monetary policy to lower the unemployment rate below the natural rate on a sustained basis will end in failure. Initially, expansionary monetary policy would lower unemployment as well as raise inflation. As the stimulus continued, however, firms and workers would increasingly protect themselves against the higher inflation, giving an additional boost to inflation. Eventually, there would be no additional employment; only a (self-reinforcing) higher rate of inflation.

In 1970, the Federal Reserve held a conference that addressed this then-new framework; the conference encompassed both theoretical extensions, including Lucas' first exposition of rational expectations, and empirical implementation.³ In its essentials, the way we forecast inflation today is not all that different from what came out of that conference. That is, inflation is importantly a function of an output or employment gap relative to a natural rate, plus some measure of inflation expectations.

Advances within the Basic Framework
One of the first challenges that the new framework had to face was the supply shocks of the early 1970s. The framework was extended to allow for the effects of shifts in relative prices, such as crude oil and import prices. Such shifts can feed through fairly directly to the measures of core inflation through their effect on business costs, though their influence on inflation should be temporary unless they get built into labor costs or inflation expectations. We include these types of price terms today in our forecasting equations, and they are important to forming our views of the inflation outlook and thus to the policy process.

Another early development within the framework was the buttressing of its microeconomic foundations, in particular by paying more careful attention to the modeling of nominal rigidities. John Taylor's staggered-contracts framework remains a touchstone because of its intuitive appeal--annual wage reviews are a familiar experience for most people who work. Much subsequent work--including, recently, among economists at the European Central Bank and the euro-area national central banks--has confirmed the key assumption underlying this model, which is that wages and prices are changed infrequently.

A key objective of Taylor's staggered-contracts model was to show that, in an economy with nominal rigidities, monetary policy can have important effects even when expectations are perfectly rational. However, about a decade ago, Jeff Fuhrer and George Moore pointed out that inflation was more persistent than was predicted by the model with sticky prices and rational expectations.⁴ Since their work, a number of researchers have suggested that "sticky information" or rules of thumb can account for this excess persistence. Such departures of expectations from perfect rationality can be an important source of observed inflation dynamics.

At the Fed, the staff takes a number of different approaches to the modeling of expectations. The staff's large, formal model (FRB/US) assumes rational expectations--but with a twist. In particular, the model addresses the Fuhrer-Moore critique by making inflation itself, as well as the levels of wages and prices, costly to adjust. The implications of these additional frictions are very similar to those of the departures of expectations from perfect rationality used by other modelers. An advantage of a model with expectations that are, at least in part, rational is that we can address questions related to how the behavior of the economy may change when the systematic implementation of monetary policy changes.

We also look at models that assume that inflation expectations are well modeled by lagged inflation--the original proposal of Friedman and of Phelps. Such models may not be as useful in addressing policy questions. However, they have a good forecasting track record.

The Performance of the Board Staff's Inflation Forecast
The Board staff forecasts distributed to the Federal Open Market Committee (FOMC) are judgmental: Although the staff consults a variety of models in coming up with its forecasts, no one model can be said to summarize the staff view. Also, the staff forecasts are not necessarily its best guess on how inflation will evolve; the forecasts are conditioned on an assumed path for monetary policy and, during some periods, at the behest of policymakers, the staff did not assume what it would have viewed as the most likely policy path.

I have distributed a figure that shows the Board staff's four-quarter-ahead forecasts for inflation as measured by the core Consumer Price Index along with the actual outcomes. The period shown is 1984 to 2000; I chose those years because the current definition of the core CPI did not come into use until 1983, and the staff's forecasts remain confidential for five years.

As shown in the inset box, the root-mean-squared error of the staff projections has been smaller than that of a na?e benchmark model, in which inflation is assumed to continue at its pace over the preceding four quarters. Nonetheless, the one-year-ahead root-mean-squared error of the staff forecast is about 1/2 percentage point. That is to say, almost one-third of the time, inflation has been either more than 1/2 percentage point higher, or more than 1/2 percentage point lower, than the staff has predicted. Moreover, over the period shown, there was, on average, some bias in the staff's inflation forecasts; inflation has tended to come in lower than the staff anticipated, by about 0.2 percentage point per year.

No single explanation suggests itself for either the extent of the misses or the bias. Rather, a variety of factors has caused inflation to deviate from expectations.⁵ At times, demand was not as robust as anticipated, and unexpected but persistent changes in the foreign exchange value of the dollar and oil prices fed through to core CPI inflation on several occasions. But I will concentrate on one general phenomenon and two episodes that help illustrate how our understanding has evolved and some of the more general challenges for inflation forecasting over the past twenty years.

One factor that may account for some of the upward bias over this entire period was a gradual reduction in the natural rate of unemployment. With hindsight, I believe we can point to a number of developments in labor markets that are consistent with such a reduction. For example, disability insurance rolls rose steadily over this period, which allowed many people who likely would have had above-average unemployment rates to withdraw from the labor force. Also, in the early 1990s, many public opinion surveys indicated a sharp increase in worker insecurity--and workers who are anxious about losing their jobs will be less willing to risk unemployment. These examples illustrate the need to be alert to the possibility of the natural rate shifting. As Friedman emphasized, the natural rate is not a rigid data point, but rather the reflection of many developments in the economy.

In the 1988-90 period, the behavior of crude oil prices, unemployment, and the exchange rate were not especially surprising or anomalous. However, the models the staff was consulting in preparing its forecasts may have been miscalibrated. In particular, inflation expectations perhaps were becoming better anchored, so that an unemployment rate below the natural rate was putting less pressure on inflation than it would have over the preceding twenty years. Likewise, the staff may have overestimated the ongoing effects of the dollar decline on inflation, as the models in use at that time inevitably gave considerable weight to the experience of the 1970s. Empirical estimates unavoidably lag these sorts of endogenous changes in inflation dynamics.

For the period from 1996 to 1998, inflation also came in consistently lower than the staff forecast. Here, the pick up in structural productivity growth was the likely cause: The historical record suggests that a sustained acceleration in productivity affects prices before it affects wages. Thus, the pickup in productivity growth has a direct, depressing effect on costs--and thus ultimately on prices. It took Fed forecasters--and others--a while to discern the acceleration in productivity and its implications for inflation. Interestingly, by the time of the forecasts made in 1998 and 1999--the 1999 and 2000 observations on the chart--the string of forecasting errors had ended. This improved performance likely reflected the eventual recognition that productivity growth had increased on a sustained basis.

An Agenda for Further Research
As I noted at the beginning of my remarks, research aimed at improving our understanding of and ability to predict inflation is essential to the central banker's mission. The better the forecasts, the better the odds that policy choices will contribute to economic stability and efficient resource allocation. Needless to say, more work remains to be done--and always will. My chart stops at 2000, but it is no secret that forecasters everywhere did not anticipate the extent of disinflation in the U.S. economy in 2003 and, even after the fact, have had trouble explaining what happened. Moreover, the degree to which core inflation picked up in 2004 and 2005 also caught many economists, including this one on the FOMC, by surprise.

Surprises are inevitable; aggregate supply and demand curves shift for reasons that cannot be anticipated. But improvement should be possible in several dimensions. We could identify shocks sooner and get a better understanding of their likely effects on inflation. And we could attempt to narrow the definition of "shock." I suspect that much of what we consider to be exogenous is the working out of endogenous events that we do not understand very well.

Better predictions inevitably begin with improved understanding--both theoretical and empirical. In reviewing some of the advances of the past thirty-five years for this talk, I was struck by the degree to which so much of the work on rigidities and expectations seemed to be trying to find an elegant rationale at the level of the firm and the worker for the observed dynamic properties of aggregate price measures. This work, while illuminating in many respects, does not seem to have greatly advanced the empirical forecasting of inflation. And, the microeconomic behaviors we describe to justify the empirical specifications of our macroeconomic models often do not coincide very well with what we find when we directly observe the decisionmaking of workers and firms. I think we need to push forward along these microeconomic lines. I have a lengthy list of macroeconomic inflation puzzles whose answers would make me a better policymaker, but, for the most part, the solutions to the puzzles rest on a better understanding of how workers and firms set wages and prices.

Researchers at the ECB and at the euro-area national central banks have made an important contribution in their recent work. I agree with one of the conclusions I understand many of them came to--that is, we especially need to improve our understanding of the determinants of labor compensation. The reduced-form price equations we so often use for inflation prediction bypass direct contact with labor compensation issues. But the labor market is at the foundation of the Friedman-Phelps analysis. Labor is the major element of business cost and as such often occupies a prominent role in policy discussions of inflation prospects, and the unemployment rate often proxies for resource slack more generally. As I have already discussed, unanticipated changes in the natural rate have contributed to forecasting errors over the past two decades. In the past few years, we have had some experience with wage setting under conditions of price stability, and nominal compensation showed greater flexibility than some observers had anticipated. Too often, discussions of wage and compensation determination rely on descriptions of worker demands and expectations that seem drawn from an era of strong unions rather than from the more atomistic labor markets that dominate the U.S. economy these days.

A better understanding of the motivation and dynamics of how compensation is determined between firms and individuals or small groups of workers would help unravel a number of the inflation puzzles I think we face, including those involving productivity growth, globalization, markups, and expectations formation.

Changes in Productivity Growth
An important aspect of this story has been that productivity affects prices before it affects wages--that is why we were able to experience low and stable inflation in the latter part of the 1990s with the unemployment rate well below any estimates of its natural level. But is it really true that prices are more responsive to productivity than wages? Why? Should the effects be symmetrical when productivity growth slows? How can we better estimate structural productivity and determine changes in its pace of growth more promptly?

Globalization and the Inflation Process
Several observers have argued that increased trade has been an important factor in the downtrend in inflation over the past two decades.⁶ One channel is said to be through greater competitive pressures and another through increased support for price stability engendered by the competitive environment. Globalization might restrain prices and wages in those sectors in which imports play an increasing role, but how does it hold back the average wage and price level? And, how do we reconcile the sense of greater competitive pressures with record levels of profits--and capital income more generally--in the United States?

The Behavior of Profit Margins or Markups
The Federal Reserve's 1970 conference and much of the work since then has approached the determination of inflation as a two-step process: model both labor costs and the price markup over labor costs. Yet, we find that this approach does not work very well in practice. Years of experience suggest that although profit margins tend to return to their mean, deviations can increase for a time and the eventual return can be slow and very difficult to predict. In the United States, markups have remained unusually elevated of late, absorbing little of the rise in the cost of energy, import, and materials. Does it matter whether the shock to margins comes from a change in potential supply or aggregate demand? What type of pricing behavior reconciles these outcomes? How are they consistent with the expectation that margins return to means?

Inflation Expectations
Measures of inflation expectations are among the variables I watch most closely as I formulate my policy recommendations because I recognize that changing expectations are a principal avenue by which short-term perturbations in price levels are propagated into more persistent changes in inflation rates. Yet our knowledge of the expectations that businesses and workers bring to the process of setting wages and prices is extremely limited. We use proxies--most often surveys of economists, whose projections may be influenced by their knowledge of other economists' projections, and of households, who may or may not understand the question or have a realistic view of what to expect. Readings from the financial markets are helpful, but they are also muddied by changing premiums for inflation risk and liquidity, and they are not necessarily representative of the attitudes of households or businesses.

Moreover, how expectations are formed remains an area that would benefit from further research. How much do people rely on the immediate past in forming expectations about the future? To what extent are projections from the past modified by what they know about the goals of the central bank or the stage and characteristics of the current economic cycle? How often do expectations get updated, and what types of information are used in the process?

* * *

This is a daunting research agenda, but it should be given a high priority. I appreciate the opportunity to spell it out before an audience that has the skills and the opportunity to address some of these pressing questions.

Footnotes

1.  The views I am expressing today are my own and not necessarily those of my colleagues on the Federal Open Market Committee. John Roberts, of the Board's staff, helped with the preparation of these remarks.  Return to text

2.  Milton Friedman (1968), "The Role of Monetary Policy," American Economic Review, vol. 58 (March), pp. 1-17; Edmund S. Phelps (1968), "Money-Wage Dynamics and Labor-Market Equilibrium," Journal of Political Economy, vol. 76 (July-August, part 2: Issues in Monetary Research), pp. 678-711.  Return to text

3.  The Econometrics of Price Determination (1972), proceedings of a conference sponsored by the Board of Governors of the Federal Reserve System and the Social Science Research Council, October 30-31, 1970 (Washington: Board of Governors of the Federal Reserve System). Return to text

4.  Jeff Fuhrer and George Moore (1995), "Inflation Persistence," Quarterly Journal of Economics, vol. 110 (February), pp. 127- 59. Return to text

5.  The discussion of the forecasting record that follows is largely a matter of conjecture and guesswork. It is hard to pinpoint the cause of any particular forecast error. I am drawing on my own memories of events, as well as those of current members of the Board's staff.  Return to text

6.  Kenneth S. Rogoff (2003), "Globalization and Global Disinflation," in Monetary Policy and Uncertainty: Adapting to a Changing Economy, proceedings of a symposium sponsored by the Federal Reserve Bank of Kansas City, August 28-30 (Kansas City: Federal Reserve Bank of Kansas City), pp. 77-112; Alan Greenspan (2005), "Globalization," speech presented to the Council on Foreign Relations, March 10. Return to text

Last update: May 20, 2005