Last week I responded to a Greg Ip Wall Street Journal titled "Policy Makers At Fed Rethink Inflation Roots" with the following comment: "Remember the "New Economy"? File this story with that one." That prompted Gabriel Mihalache to ask:
Is he saying that the NAIRU is B.S., like the “New Economy”, or are the criticisms of the NAIRU which are not OK? … Huh….
I confess that the comment was probably a bit obscure, so let me elaborate. Quite awhile back -- going on two years now -- I made note of these remarks, from Fed Governor Don Kohn:
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.
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…
Mark Thoma has a nice simple exposition of the basic idea, and (in a separate post) some right-on-target comments from a paper by Jim Stock and Mark Watson about why
The "reduced-form" version of this framework
In the reduced-form version of this framework