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by Jeffrey M. Lacker and John A. Weinberg
Inflation and Unemployment:
A Layperson’s Guide to the Phillips Curve
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2006 Annual Report ■Page 5
What do you remember from the economics class you took in college? Even if you didn’t
take economics, what basic ideas do you think are important for understanding the way
markets work? In either case, one thing you might come up with is that when the demand
for a good rises—when more and more people want more and more of that good—its price
will tend to increase. This basic piece of economic logic helps us understand the phenom-
ena we observe in many specific markets—from the tendency of gasoline prices to rise
as the summer sets in and people hit the road on their family vacations, to the tendency
for last year’s styles to fall in price as consumers turn to the new fashions.
This notion paints a picture of the price of a good moving together in the same direction
with its quantity—when people are buying more, its price is rising. Of course supply
matters, too, and thinking about variations in supply—goods becoming more or less
plentiful or more or less costly to produce—complicates the picture. But in many cases
such as the examples above, we might expect movements up and down in demand to
happen more frequently than movements in supply. Certainly for goods produced by a
stable industry in an environment of little technological change, we would expect that
many movements in price and quantity are driven by movements in demand, which
would cause price and quantity to move up and down together. Common sense suggests
that this logic would carry over to how one thinks about not only the price of one
good but also the prices of all goods. Should an average measure of all prices in the
economy—the consumer price index, for example—be expected to move up when our
total measures of goods produced and consumed rise? And should faster growth in
these quantities—as measured, say, by gross domestic product—be accompanied
by faster increases in prices? That is, should inflation move up and down with real
economic growth?
The authors are respectively President and Senior Vice President and Director of Research.
The views expressed are the authors’ and not necessarily those of the Federal Reserve System.
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Page 6 ■ Federal Reserve Bank of Richmond
The simple intuition behind this series of questions
is seriously incomplete as a description of the behav-
ior of prices and quantities at the macroeconomic
level. But it does form the basis for an idea at the
heart of much macroeconomic policy analysis for at
least a half century. This idea is called the “Phillips
curve,” and it embodies a hypothesis about the rela-
tionship between inflation and real economic vari-
ables. It is usually stated not in terms of the positive
relationship between inflation and growth but in terms
of a negative relationship between inflation and
unemployment. Since faster growth often means
more intensive utilization of an economy’s resources,
faster growth will be expected to come with falling
unemployment. Hence, faster inflation is associated
with lower unemployment. In this form, the Phillips
curve looks like the expression of a trade-off between
two bad economic outcomes—reducing inflation
requires accepting higher unemployment.
The first important observation about this relation-
ship is that the simple intuition described at the begin-
ning of this essay is not immediately applicable at the
level of the economy-wide price level. That intuition is
built on the workings of supply and demand in setting
the quantity and price of a specific good. The price
of that specific good is best understood as a relative
price—the price of that good compared to the prices
of other goods. By contrast, inflation is the rate of
change of the general level of all prices. Recognizing
this distinction does not mean that rising demand for
all goods—that is, rising aggregate demand—would
not make all prices rise. Rather, the important impli-
cation of this distinction is that it focuses attention on
what, besides people’s underlying desire for more
goods and services, might drive a general increase in
all prices. The other key factor is the supply of money
in the economy.
Economic decisions of producers and consumers
are driven by relative prices: a rising price of bagels
relative to doughnuts might prompt a baker to shift
production away from doughnuts and toward bagels.
If we could imagine a situation in which all prices of
all outputs and inputs in the economy, including
wages, rise at exactly the same rate, what effect on
economic decisions would we expect? A reasonable
answer is “none.” Nothing will have become more
expensive relative to other goods, and labor income
will have risen as much as prices, leaving people no
poorer or richer.
The thought experiment involving all prices and
wages rising in equal proportions demonstrates the
principle of monetary neutrality. The term refers to the
fact that the hypothetical increase in prices and wages
could be expected to result from a corresponding
increase in the supply of money. Monetary neutrality
is a natural starting point for thinking about the
relationship between inflation and real economic
variables. If money is neutral, then an increase in the
supply of money translates directly into inflation and
has no necessary relationship with changes in real
output, output growth, or unemployment. That is,
when money is neutral, the simple supply-and-
demand intuition about output growth and inflation
does not apply to inflation associated with the growth
of the money supply.
The logic of monetary neutrality is indisputable, but
is it relevant? The logic arises from thinking about
This idea is called the ‘Phillips curve,’ and it
embodies a hypothesis about the relationship
between inflation and real economic variables. It
is usually stated. . .in terms of a negative relation-
ship between inflation and unemployment.
”
“
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2006 Annual Report ■ Page 7
hypothetical “frictionless” economies in which all mar-
ket participants at all times have all the information
they need to price the goods they sell and to choose
among the available goods, and in which sellers can
easily change the price they charge. Against this
hypothetical benchmark, actual economies are likely
to appear imperfect to the naked eye. And under the
microscope of econometric evidence, a positive corre-
lation between inflation and real growth does tend to
show up. The task of modern macroeconomics has
been to understand these empirical relationships.
What are the “frictions” that impede monetary neu-
trality? Since monetary policy is a key determinant of
inflation, another important question is how the con-
duct of policy affects the observed relationships. And
finally, what does our understanding of these relation-
ships imply about the proper conduct of policy?
The Phillips curve, viewed as a way of capturing
how money might not be neutral, has always been a
central part of the way economists have thought
about macroeconomics and monetary policy. It also
forms the basis, perhaps implicitly, of popular under-
standing of the basic problem of economic policy:
namely, we want the economy to grow and unem-
ployment to be low, but if growth is too robust,
inflation becomes a risk. Over time, many debates
about economic policy have boiled down to alterna-
tive understandings of what the Phillips curve is and
what it means. Even today, views that economists
express on the effects of macroeconomic policy in
general and monetary policy in particular often derive
from what they think about the nature, the shape, and
the stability of the Phillips curve.
This essay seeks to trace the evolution of our
understanding of the Phillips curve, from before its
inception to contemporary debates about economic
policy. The history presented in the pages that follow
is by no means exhaustive. Important parts of econ-
omists’ understanding of this relationship that we neg-
lect include discussions of how the observed Phillips
curve’s statistical relationship could emerge even
under monetary neutrality.1We also neglect the liter-
ature on the possibility of real economic costs of
inflation that arise even when money is neutral.2
Instead, we seek to provide the broad outlines of the
intellectual development that has led to the role of
the Phillips curve in modern macroeconomics,
emphasizing the interplay of economic theory and
empirical evidence.
After reviewing the history, we will turn to the cur-
rent debate about the Phillips curve and how it trans-
lates into differing views about monetary policy.
People commonly talk about a central bank seeking
to engineer a slowing of the economy to bring about
lower inflation. They think of the Phillips curve as
describing how much slowing is required to achieve a
given reduction in inflation. We believe that this read-
ing of the Phillips curve as a lever that a policymaker
might manipulate mechanically can be misleading. By
itself, the Phillips curve is a statistical relationship that
has arisen from the complex interaction of policy deci-
sions and the actions of private participants in the
economy. Importantly, choices made by policymakers
play a large role in determining the nature of the sta-
tistical Phillips curve. Understanding that relation-
ship—between policymaking and the Phillips curve—
is a key ingredient to sound policy decisions. We
return to this theme after our historical overview.
Some History
The Phillips curve is named for New Zealand-born
economist A. W. Phillips, who published a paper in
1958 showing an inverse relationship between (wage)
inflation and unemployment in nearly 100 years of
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data from the United Kingdom.3Since this is the work
from which the curve acquired its name, one might
assume that the economics profession’s prior consen-
sus on the matter embodied the presumption that
money is neutral. But this in fact is not the case.
The idea of monetary neutrality has long coexisted
with the notion that periods of rising money growth
and inflation might be accompanied by increases in
output and declines in unemployment. Robert Lucas
(1996), in his Nobel lecture on the subject of mone-
tary neutrality, finds both ideas expressed in the work
of David Hume in 1752! Thomas Humphrey (1991)
traces the notion of a Phillips curve trade-off through-
out the writings of the classical economists in the
eighteenth and nineteenth centuries. Even Irving
Fisher, whose statement of the quantity theory of
money embodied a full articulation of the conse-
quences of neutrality, recognized the possible real
effects of money and inflation over the course of a
business cycle.
In early writings, these two opposing ideas—that
money is neutral and that it is associated with rising
real growth—were typically reconciled by the distinc-
tion between periods of time ambiguously referred to
as “short-run” and “long-run.” The logic of monetary
neutrality is essentially long-run logic. The type of
thought experiment the classical writers had in mind
was a one-time increase in the quantity of money
circulating in an economy. Their logic implied that,
ultimately, this would merely amount to a change in
units of measurement. Given enough time for the
extra money to spread itself throughout the economy,
all prices would rise proportionately. So while the
number of units of money needed to compensate a
day’s labor might be higher, the amount of food,
shelter, and clothing that a day’s pay could purchase
would be exactly the same as before the increase in
money and prices.
Against this logic stood the classical economists’
observations of the world around them in which
increases in money and prices appeared to bring
increases in industrial and commercial activity. This
empirical observation did not employ the kind of
formal statistics as that used by modern economists
but simply the practice of keen observation. They
would typically explain the difference between their
theory’s predictions (neutrality) and their observations
by appealing to what economists today would call
“frictions” in the marketplace. Of particular importance
in this instance are frictions that get in the way of
price adjustment or make it hard for buyers and sell-
ers of goods and services to know when the general
level of all prices is rising. If a craftsman sees that he
can sell his wares for an increased price but doesn’t
realize that all prices are rising proportionately, he
might think that his goods are rising in value relative
to other goods. He might then take action to increase
his output so as to benefit from the perceived rise in
the worth of his labors.
This example shows how frictions in price adjust-
ment can break the logic of money neutrality. But
such a departure is likely to be only temporary. You
can’t fool everybody forever, and eventually people
learn about the general inflation caused by an increase
in money. The real effects of inflation should then
die out. It was in fact in the context of this distinction
In early writings, these two opposing ideas—
that money is neutral and that it is associated
with rising real growth—were typically recon-
ciled by the distinction between periods of
time ambiguously referred to as ‘short-run’ and
‘long-run.’
”
“
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2006 Annual Report ■ Page 9
between long-run neutrality and the short-run trade-off
between inflation and real growth that John Maynard
Keynes made his oft-quoted quip that “in the long run
we are all dead.”4
Phillips’ work was among the first formal statistical
analyses of the relationship between inflation and real
economic activity. The data on the rate of wage
increase and the rate of unemployment for Phillips’
baseline period of 1861–1913 are reproduced in
Figure 1. These data show a clear negative relation-
ship—greater inflation tends to coincide with lower
unemployment. To highlight that relationship, Phillips fit
the curve in Figure 1 to the data. He then examined a
number of episodes, both within the baseline period
and in other periods up through 1957. The general
tendency of a negative relationship persists throughout.
Crossing the Atlantic
A few years later, Paul Samuelson and Robert Solow,
both eventual Nobel Prize winners, took a look at the
U.S. data from the beginning of the twentieth century
through 1958.5A similar scatter-plot to that in Figure 1
was less definitive in showing the negative relation-
ship between wage inflation and unemployment.
The authors were able to recover a pattern similar to
Phillips’ by taking out the years of the World Wars and
the Great Depression. They also translated their find-
ings into a relationship between unemployment and
price inflation. It is this relationship that economists
now most commonly think of as the “Phillips curve.”
Samuelson and Solow’s Phillips curve is repro-
duced in Figure 2. (See page 10.) They interpret this
curve as showing the combinations of unemployment
and inflation available to society. The implication is
that policymakers must choose from the menu traced
out by the curve. An inflation rate of zero, or price sta-
bility, appears to require an unemployment rate of
about 51⁄2percent. To achieve unemployment of about
3 percent, which the authors viewed as approximately
full employment, the curve suggests that inflation
would need to be close to 5 percent.
Samuelson and Solow did not propose that their
estimated curve described a permanent relationship
that would never change. Rather, they presented it as
a description of the array of possibilities facing the
economy in “the years just ahead.”6While recogniz-
ing that the relationship might change beyond this
near horizon, they remained largely agnostic on how
and why it might change. As a final note, however,
they suggest institutional reforms that might produce
a more favorable trade-off (shifting the curve in
Figure 2 down and to the left). These involve meas-
ures to limit the ability of businesses and unions to
exercise monopoly control over prices and wages, or
even direct wage and price controls. Their closing
discussion suggests that they, like many economists
at the time, viewed both inflation and the frictions
that kept money and inflation from being neutral
as at least partly structural—hard-wired into the
institutions of modern, corporate capitalism. Indeed,
they concluded their paper with speculation about
institutional reforms that could move the Phillips curve
1
10
8
6
4
2
0
-2
-4
0 7 8 9 10 1123456
UNEMPLOYMENT RATE (%)
RATE OF CHANGE OF WAGE RATE
(% PER YEAR)
Figure 1: Inflation-Unemployment Relationship in the
United Kingdom, 1861-1913
Source: Phillips (1958)
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down and to the left. This was an interpretation that
was compatible with the idea of a more permanent
trade-off that derived from the structure of the
economy and that could be exploited by policymakers
seeking to engineer lasting changes in economic
performance.
By the 1960s, then, the Phillips curve trade-off had
become an essential part of the Keynesian approach
to macroeconomics that dominated the field in the
decades following the Second World War. Guided by
this relationship, economists argued that the govern-
ment could use fiscal policy—government spending
or tax cuts—to stimulate the economy toward full
employment with a fair amount of certainty about
what the cost would be in terms of increased inflation.
Alternatively, such a stimulative effect could be
achieved by monetary policy. In either case, policy-
making would be a conceptually simple matter of
cost-benefit analysis, although its implementation
was by no means simple. And since the costs of a
small amount of inflation to society were thought
to be low, it seemed worthwhile to achieve a lower
unemployment rate at the cost of tolerating only a
little more inflation.
Turning the focus to expectations
This approach to economic policy implicitly either
denied the long-run neutrality of money or thought it
irrelevant. A distinct minority view within the profes-
sion, however, continued to emphasize limitations
on the ability of rising inflation to bring down unem-
ployment in a sustained way. The leading proponent
of this view was Milton Friedman, whose Nobel
Prize award would cite his Phillips curve work. In
his presidential address to the American Economics
Association, Friedman began his discussion of mone-
tary policy by stipulating what monetary policy cannot
do. Chief among these was that it could not “peg
the rate of unemployment for more than very limited
periods.”7Attempts to use expansionary monetary
policy to keep unemployment persistently below what
he referred to as its “natural rate” would inevitably
come at the cost of successively higher inflation.
Key to his argument was the distinction between
anticipated and unanticipated inflation. The short-run
trade-off between inflation and unemployment
depended on the inflation expectations of the public.
If people generally expected price stability (zero
inflation), then monetary policy that brought about
inflation of 3 percent would stimulate the economy,
raising output growth and reducing unemployment.
But suppose the economy had been experiencing
higher inflation, of say 5 percent, for some time,
and that people had come to expect that rate of
increase to continue. Then, a policy that brought
about 3 percent inflation would actually slow the
economy, making unemployment tend to rise.
By emphasizing the public’s inflation expectations,
Friedman’s analysis drew a link that was largely
absent in earlier Phillips curve analyses. Specifically,
his argument was that not only is monetary policy pri-
marily responsible for determining the rate of inflation
that will prevail, but it also ultimately determines the
11
10
9
8
7
6
5
4
3
2
1
0
-1
123456789
B
UNEMPLOYMENT RATE (%)
AVERAGE INCREASE IN PRICE (% PER YEAR)
A
Source: Samuelson and Solow (1960)
Figure 2: Inflation-Unemployment Relationship in the
United States around 1960
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2006 Annual Report ■ Page 11
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Page 12 ■ Federal Reserve Bank of Richmond
location of the entire Phillips curve. He argued that
the economy would be at the natural rate of unem-
ployment in the absence of unanticipated inflation.
That is, the ability of a small increase in inflation to
stimulate economic output and employment relied on
the element of surprise. Both the inflation that people
had come to expect and the ability to create a surprise
were then consequences of monetary policy decisions.
Friedman’s argument involved the idea of a “natural
rate” of unemployment. This natural rate was some-
thing that was determined by the structure of the
economy, its rate of growth, and other real factors
independent of monetary policy and the rate of infla-
tion. While this natural rate might change over time,
at any point in time, unemployment below the natural
rate could only be achieved by policies that created
inflation in excess of that anticipated by the public.
But if inflation remained at the elevated level, people
would come to expect higher inflation, and its stimula-
tive effect would be lost. Unemployment would move
back toward its natural rate. That is, the Phillips curve
would shift up and to its right, as shown in Figure 3.
The figure shows a hypothetical example in which
the natural rate of unemployment is 5 percent and
people initially expect inflation of 1 percent. A surprise
inflation of 3 percent drives unemployment down to
3 percent. But sustained inflation at the higher rate
ultimately changes expectations, and the Phillips curve
shifts back so that the natural rate of unemployment
is achieved but now at 3 percent inflation. This analy-
sis, which takes account of inflation expectations, is
referred to as the expectations-augmented Phillips
curve. An independent and contemporaneous devel-
opment of this approach to the Phillips curve was
given by Edmund Phelps, winner of the 2006 Nobel
Prize in economics.8Phelps developed his version of
the Phillips curve by working through the implications
of frictions in the setting of wages and prices, which
anticipated much of the work that followed.
The reasoning of Friedman and Phelps implied that
attempts to exploit systematically the Phillips curve to
bring about lower unemployment would succeed only
temporarily at best. To have an effect on real activity,
monetary policy needed to bring about inflation in
excess of people’s expectations. But eventually,
people would come to expect higher inflation, and
the policy would lose its stimulative effect. This insight
comes from an assumption that people base their
expectations of inflation on their observation of past
inflation. If, instead, people are more forward looking
and understand what the policymaker is trying to do,
they might adjust their expectations more quickly,
causing the rise in inflation to lose much of even its
temporary effect on real activity. In a sense, even the
short-run relationship relied on people being fooled.
One way people might be fooled is if they are simply
unable to distinguish general inflation from a change
in relative prices. This confusion, sometimes referred
to as money illusion, could cause people to react to
inflation as if it were a change in relative prices. For
1 2 4 5 6783
INFLATION RATE (%)
UNEMPLOYMENT RATE (%)
8
7
6
5
4
3
2
1
u*
Figure 3: Expectations-Augmented Phillips Curve
Note: When expected inflation is 1 percent, an unanticipated increase
in inflation will initially bring unemployment down. But expectations will
eventually adjust, bringing unemployment back to its natural rate (u*)
at the higher rate of inflation.
AR_inside 6/5/07 8:05 AM Page 12
instance, workers, seeing their nominal wages rise
but not recognizing that a general inflation is in
process, might react as if their real income were ris-
ing. That is, they might increase their expenditures on
goods and services.
Robert Lucas, another Nobel Laureate, demonstrated
how behavior resembling money illusion could result
even with firms and consumers who fully understood
the difference between relative prices and the general
price level.9In his analysis, confusion comes not from
people’s misunderstanding, but from their inability to
observe all of the economy’s prices at one time. His
was the first formal analysis showing how a Phillips
curve relationship could emerge in an economy with
forward-looking decisionmakers. Like the work of
Friedman and Phelps, Lucas’ implications for policy-
makers were cautionary. The relationship between
inflation and real activity in his analysis emerged
most strongly when policy was conducted in an
unpredictable fashion, that is, when policymaking
was more a source of volatility than stability.
The Great Inflation
The expectations-augmented Phillips curve had the
stark implication that any attempt to utilize the rela-
tionship between inflation and real activity to engineer
persistently low unemployment at the cost of a little
more inflation was doomed to failure. The experience
of the 1970s is widely taken to be a confirmation of
this hypothesis. The historical relationship identified
by Phillips, Samuelson and Solow, and other earlier
writers appeared to break down entirely, as shown by
the scatter plot of the data for the 1970s in Figure 4.
Throughout this decade, both inflation and unemploy-
ment tended to grow, leading to the emergence of the
term “stagflation” in the popular lexicon.
One possible explanation for the experience of the
1970s is that the decade was simply a case of bad
luck. The Phillips curve shifted about unpredictably as
the economy was battered by various external shocks.
The most notable of these shocks were the dramatic
increases in energy prices in 1973 and again later in
the decade. Such supply shocks worsened the avail-
able trade-off, making higher unemployment neces-
sary at any given level of inflation.
By contrast, viewing the decade through the lens of
the expectations-augmented Phillips curve suggests
that policy shared the blame for the disappointing
results. Policymakers attempted to shield the real
economy from the effects of aggregate shocks. Guided
by the Phillips curve, this effort often implied a choice
to tolerate higher inflation rather than allowing unem-
ployment to rise. This type of policy choice follows
from viewing the statistical relationship Phillips first
found in the data as a menu of policy options, as
suggested by Samuelson and Solow. But the
2006 Annual Report ■ Page 13
The reasoning of Friedman and Phelps implied
that attempts to exploit systematically the
Phillips curve to bring about lower unemploy-
ment would succeed only temporarily at best.
”
“
0
2
4
6
8
10
12
14
UNEMPLOYMENT RATE (%)
6
INFLATION RATE (%)
345 78910
65
95
70
90
85
80
75
61
Sources: Bureau of Labor Statistics/Haver Analytics
Note: Inflation rate is seasonally-adjusted CPI, Fourth Quarter.
Figure 4: Inflation-Unemployment Relationship in the
United States,1961-1995
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Page 14 ■ Federal Reserve Bank of Richmond
arguments made by Friedman and Phelps imply that
such a trade-off is short-lived at best. Unemployment
would ultimately return to its natural rate at the higher
rate of inflation. So, while the relative importance of
luck and policy for the poor macroeconomic perform-
ance of the 1970s continues to be debated by econo-
mists, we find a powerful lesson in the history of that
decade.10 The macroeconomic performance of the
1970s is largely what the expectations-augmented
Phillips curve predicts when policymakers try to exploit
a trade-off that they mistakenly believe to be stable.
The insights of Friedman, Phelps, and Lucas pointed
to the complicated interaction between policymaking
and statistical analysis. Relationships we observe in
past data were influenced by past policy. When policy
changes, people’s behavior may change and so too
may statistical relationships. Hence, the history of the
1970s can be read as an illustration of Lucas’ critique
of what was at the time the consensus approach to
policy analysis.11
Focusing attention on the role of expectations in the
Phillips curve creates a challenge for policymakers
seeking to use monetary policy to manage real eco-
nomic activity. At any point in time, the current state
of the economy and the private sector’s expectations
may imply a particular Phillips curve. Assuming that
Phillips curve describes a stable relationship, a policy-
maker might choose a preferred inflation-unemploy-
ment combination. That very choice, however, can
alter expectations, causing the trade-off to change.
The policymaker’s problem is, in effect, a game
played against a public that is trying to anticipate
policy. What’s more, this game is repeated over and
over, each time a policy choice must be made. This
complicated interdependence of policy choices and
private sector actions and expectations was studied
by Finn Kydland and Edward C. Prescott.12 In one
of the papers for which they were awarded the 2005
Nobel Prize, they distinguish between rules and
discretion as approaches to policymaking. By discre-
tion, they mean period-by-period decisionmaking in
which the policymaker takes a fresh look at the costs
and benefits of alternative inflation levels at each
moment. They contrast this with a setting in which
the policymaker makes a one-time decision about the
best rule to guide policy. They show that discretionary
policy would result in higher inflation and no lower
unemployment than the once-and-for-all choice of
a policy rule.
Recent work by Thomas Sargent and various co-
authors shows how discretionary policy, as studied by
Kydland and Prescott, can lead to the type of inflation
outcomes experienced in the 1970s.13 This analysis
assumes that the policymaker is uncertain of the
position of the Phillips curve. In the face of this un-
certainty, the policymaker estimates a Phillips curve
from historical data. Seeking to exploit a short-run,
expectations-augmented Phillips curve—that is, pur-
suing discretionary policy—the policymaker chooses
among inflation-unemployment combinations described
by the estimated Phillips curve. But the policy choices
themselves cause people’s beliefs about policy to
change, which causes the response to policy choices
to change. Consequently, when the policymaker uses
new data to update the estimated Phillips curve, the
curve will have shifted. This process of making policy
while also trying to learn about the location of the
Phillips curve can lead a policymaker to choices that
Focusing attention on the role of expecta-
tions in the Phillips curve creates a challenge
for policymakers seeking to use monetary
policy to manage real economic activity.
”
“
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2006 Annual Report ■ Page 15
result in persistently high inflation outcomes.
In addition to the joint rise in inflation and unem-
ployment during the 1970s, other empirical evidence
pointed to the importance of expectations. Sargent
studied the experience of countries that had suffered
from very high inflation.14 In countries where mone-
tary reforms brought about sudden and rapid deceler-
ations in inflation, he found that the cost in terms of
reduced output or increased unemployment tended to
be much lower than standard Phillips curve trade-offs
would suggest. One interpretation of these findings is
that the disinflationary policies undertaken tended to
be well-anticipated. Policymakers managed to credi-
bly convince the public that they would pursue these
policies. Falling inflation that did not come as a sur-
prise did not have large real economic costs.
On a smaller scale in terms of peak inflation rates,
another exercise in dramatic disinflation was conduct-
ed by the Federal Reserve under Chairman Paul
Volcker.15 As inflation rose to double-digit levels in the
late 1970s, contemporaneous estimates of the cost in
unemployment and lost output that would be neces-
sary to bring inflation down substantially were quite
large. A common range of estimates was that the
6 percentage-point reduction in inflation that was
ultimately brought about would require output from
9 to 27 percent below capacity annually for up to
four years.16 Beginning in October 1979, the Fed took
drastic steps, raising the federal funds rate as high
as 19 percent in 1980. The result was a steep, but
short recession. Overall, the costs of the Volcker
disinflation appear to have been smaller than had
been expected. A standard estimate, which appears
in a popular economics textbook, is one in which the
reduction in output during the Volcker disinflation
amounted to less than a 4 percent annual shortfall
relative to capacity.17 This amount is a significant
cost, but it is substantially less than many had pre-
dicted before the fact. Again, one possible reason
could be that the Fed’s course of action in this
episode became well-anticipated once it commenced.
While the public might not have known the extent of
the actions the Fed would take, the direction of the
change in policy may well have become widely
understood. By the same token, and as argued by
Goodfriend and King, remaining uncertainty about how
far and how persistently the Fed would bring inflation
down may have resulted in the costs of disinflation
being greater than they might otherwise have been.
The experience of the 1970s, together with the
insights of economists emphasizing expectations,
ultimately brought the credibility of monetary policy
to the forefront in thinking about the relationship
between inflation and the real economy. Credibility
refers to the extent to which the central bank can con-
vince the public of its intention with regard to inflation.
Kydland and Prescott showed that credibility does not
come for free. There is always a short-run gain from
allowing inflation to rise a little so as to stimulate the
real economy. To establish credibility for a low rate of
inflation, the central bank must convince the public
that it will not pursue that short-run gain.
The experience of the 1980s and 1990s can be
read as an exercise in building credibility. In several
episodes during that period, inflation expectations
rose as doubts were raised about the Fed’s ability to
maintain its commitment to low inflation. These
The experience of the 1970s, together with
the insights of economists emphasizing expec-
tations, ultimately brought the credibility of
monetary policy to the forefront in thinking
about . . . inflation and the real economy.
”
“
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2006 Annual Report ■ Page 17
episodes, labeled inflation scares by Marvin
Goodfriend, were marked by rapidly rising spreads
between long-term and short-term interest rates.18
Goodfriend identifies inflation scares in 1980, 1983,
and 1987. These tended to come during or following
episodes in which the Fed responded to real economic
weakness with reductions (or delayed increases) in its
federal funds rate target. In these instances, Fed policy-
makers reacted to signs of rising inflation expectations
by raising interest rates. These systematic policy re-
sponses in the 1980s and 1990s were an important part
of the process of building credibility for lower inflation.
The “Modern” Phillips Curve
The history of the Phillips curve shows that the empir-
ical relationship shifts over time, and there is evi-
dence that those movements are linked to the public’s
inflation expectations. But what does the history say
about why this relationship exists? Why is it that there
is a statistical relationship between inflation and real
economic activity, even in the short run? The earliest
writers and those that followed them recognized that
the short-run trade-off must arise from frictions that
stand in the way of monetary neutrality. There are
many possible sources of such frictions. They may
arise from the limited nature of the information individ-
uals have about the full array of prices for all products
in the economy, as emphasized by Lucas. Frictions
might also stem from the fact that not all people par-
ticipate in all markets, so that different markets might
be affected differently by changes in monetary policy.
One simple type of friction is a limitation on the flexi-
bility sellers have in adjusting the prices of the goods
they sell. If there are no limitations all prices can
adjust seamlessly whenever demand or cost condi-
tions change, then a change in monetary policy will,
again, affect different markets differently.
Deriving a Phillips curve from
price-setting behavior
This price-setting friction has become a popular
device for economists seeking to model the behavior
of economies with a short-run Phillips curve. To see
how such a friction leads to a Phillips curve, think
about a business that is setting a price for its product
and does not expect to get around to setting the price
again for some time. Typically, the business will
choose a price based on its own costs of production
and the demand that it faces for its goods. But
because that business expects its price to be fixed
for a while, its price choice will also depend on what
it expects to happen to its costs and its demand
between when it sets its price this time and when it
sets its price the next time.
If the price-setting business thinks that inflation will
be high in the interim between its price adjustments,
then it will expect its relative price to fall. As average
prices continue to rise, a good with a temporarily
fixed price gets cheaper. The firm will naturally be
interested in its average relative price during the peri-
od that its price remains fixed. The higher the inflation
expected by the firm up until its next price adjustment,
the higher the current price it will set. This reasoning,
applied to all the economy’s sellers of goods and serv-
ices, leads directly to a close relationship between
current inflation and expected future inflation.
This description of price-setting behavior implies
that current inflation depends on the real costs of
production and expected future inflation. The real
costs of production for businesses will rise when the
aggregate use of productive resources rises, for
instance because rising demand for labor pushes up
real wages.19 The result is a Phillips curve relationship
between inflation and a measure of real economic
activity, such as output growth or unemployment.
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Current inflation rises with expected future inflation
and falls as current unemployment rises relative to its
“natural” rate (or as current output falls relative to the
trend rate of output growth).
A Phillips curve in a “complete” modern model
The price-setting frictions that are part of many mod-
ern macroeconomic models are really not that differ-
ent from arguments that economists have always
made about reasons for the short-run non-neutrality
of money. What distinguishes the modern approach is
not just the more formal, mathematical derivation of a
Phillips curve relationship, but more importantly, the
incorporation of this relationship into a complete
model of the macroeconomy. The word “complete”
here has a very specific meaning, referring to what
economists call “general equilibrium.” The general
equilibrium approach to studying economic activity
recognizes the interdependence of disparate parts of
the economy and emphasizes that all macroeconomic
variables such as GDP, the level of prices, and
unemployment are all determined by fundamental
economic forces acting at the level of individual
households and businesses. The completeness of a
general equilibrium model also allows for an analysis
of the effects of alternative approaches to macroeco-
nomic policy, as well as an evaluation of the relative
merits of alternative policies in terms of their effects on
the economic well-being of the people in the economy.
The Phillips curve is only one part of a complete
macroeconomic model—one equation in a system
of equations. Another key component describes
how real economic activity depends on real interest
rates. Just as the Phillips curve is derived from a
description of the price-setting decisions of business-
es, this other relationship, which describes the
demand side of the economy, is based on house-
holds’ and business’ decisions about consumption
and investment. These decisions involve people’s
demand for resources now, as compared to their
expected demand in the future. Their willingness to
trade off between the present and the future depends
on the price of that trade-off—the real rate of interest.
One source of interdependence between different
parts of the model—different equations—is in the real
rate of interest. A real rate is a nominal rate—the
interest rates we actually observe in financial mar-
kets—adjusted for expected inflation. Real rates
are what really matter for households’ and firms’
decisions. So on the demand side of the economy,
people’s choices about consumption and investment
depend on what they expect for inflation, which comes,
in part, from the pricing behavior described by the
Phillips curve. Another source of interdependence
comes in the way the central bank influences nominal
interest rates by setting the rate charged on overnight,
interbank loans (the federal funds rate in the United
States). A complete model also requires a description
of how the central bank changes its nominal interest
rate target in response to changing economic con-
ditions (such as inflation, growth, or unemployment).
In a complete general equilibrium analysis of an
economy’s performance, all three parts—the Phillips
curve, the demand side, and central bank behavior—
work together to determine the evolution of economic
variables. But many of the economic choices people
make on a day-to-day basis depend not only on con-
ditions today, but also on how conditions are expected
to change in the future. Such expectations in modern
macroeconomic models are commonly described
through the assumption of rational expectations. This
assumption simply means that the public—households
and firms whose decisions drive real economic
activity—fully understands how the economy evolves
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2006 Annual Report ■ Page 19
over time and how monetary policy shapes that
evolution. It also means that people’s decisions will
depend on well-informed expectations not only of the
evolution of future fundamental conditions, but of
future policy as well. While discussions of a central
bank’s credibility typically assume that there are
things related to policymaking about which the public
is not fully certain, these discussions retain the pre-
sumption that people are forward looking in trying to
understand policy and its impact on their decisions.
Implications and uses of the modern approach
A Phillips curve that is derived as part of a model that
includes price-setting frictions is often referred to as
the New Keynesian Phillips curve (NKPC).20 A com-
plete general equilibrium model that incorporates this
version of the Phillips curve has been referred to as
the New Neoclassical Synthesis model.21 These
models, like any economic model, are parsimonious
descriptions of reality. We do not take them as exact
descriptions of how a modern economy functions.
Rather, we look to them to capture the most important
forces at work in determining macroeconomic out-
comes. The key equations in new neoclassical or new
Keynesian models all involve assumptions or approxi-
mations that simplify the analysis without altering the
fundamental economic forces at work. Such simplifica-
tions allow the models to be a useful guide to our
thinking about the economy and the effects of policy.
The modern Phillips curve is similar to the expecta-
tions-augmented Phillips curve in that inflation expec-
tations are important to the relationship between
current inflation and unemployment. But its derivation
from forward-looking price-setting behavior shifts the
emphasis to expectations of future inflation. It has
implications similar to the long-run neutrality of
money, because if inflation is constant over time, then
current inflation is equal to expected inflation. Then,
whatever that constant rate of inflation, unemploy-
ment must return to the rate implied by the underlying
structure of the economy, that is, to a rate that might
be considered the “natural” unemployment. Money is
not truly neutral in these models, however. Rather,
the pricing frictions underlying the models imply that
there are real economic costs to inflation. Because
sellers of goods adjust their prices at different times,
inflation makes the relative prices of different goods
vary, and this distorts sellers’ and buyers’ decisions.
This distortion is greater, the greater the rate of inflation.
The expectational nature of the Phillips curve also
means that policies that have a short-run effect on
inflation will induce real movements in output or
unemployment mainly if the short-run movement in
inflation is not expected to persist. In this sense, the
modern Phillips curve also embodies the importance
of monetary policy credibility, since it is credibility that
would allow expected inflation to remain stable, even
as inflation fluctuated in the near term.
A more general way of emphasizing the importance
of credibility is to say that the modern Phillips curve
implies that the behavior of inflation will depend
crucially on people’s understanding of how the central
bank is conducting monetary policy. What people
think about the central bank’s objectives and strategy
will determine expectations of inflation, especially
over the long run. Uncertainty about these aspects of
policy will cause people to try to make inferences
The modern Phillips curve also embodies the
importance of monetary policy credibility, since
it is credibility that would allow expected
inflation to remain stable, even as inflation
fluctuated in the near term.
”
“
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Page 20 ■ Federal Reserve Bank of Richmond
about future policy from the actual policy they observe.
Even if the central bank makes statements about its
long-run objectives and strategy, people will still try to
make inferences from the policy actions they see. But
in this case, the inference that people will try to make
is slightly simpler: people must determine if actual
policy is consistent with the stated objectives.
Does this newest incarnation of the Phillips curve
present a central bank with the opportunity to actively
manage real economic activity through choosing more
or less inflationary policies? The assumption that peo-
ple are forward looking in forming expectations about
future policy and inflation limits the scope for manag-
ing real growth or unemployment through Phillips
curve trade-offs. An attempt to manage such growth
or unemployment persistently would translate into the
public’s expectations of inflation causing the Phillips
curve to shift. This is another characteristic that the
modern approach shares with the older expectations-
augmented Phillips curve.
What this modern framework does allow is the
analysis of alternative monetary policy rules—that is,
how the central bank sets its nominal interest rate in
response to such economic variables as inflation,
relative to the central bank’s target, and the unem-
ployment rate or the rate of output growth relative to
the central bank’s understanding of trend growth.22
A typical rule that roughly captures the actual behavior
of most central banks would state, for instance, that
the central bank raises the interest rate when inflation
is higher than its target and lowers the interest rate
when unemployment rises. Alternative rules might
make different assumptions, for instance, about how
much the central bank moves the interest rate in
response to changes in the macroeconomic variables
that it is concerned about. The complete model can
then be used to evaluate how different rules perform
in terms of the long-run levels of inflation and unem-
ployment they produce, or more generally in terms of
the economic well-being generated for people in the
economy. A typical result is that rules that deliver lower
and less variable inflation are better both because low
and stable inflation is a good thing and because such
rules can also deliver less variability in real economic
activity. Further, lower inflation has the benefit of
reducing the costs from distorted relative prices.
While low inflation is a preferred outcome, it is typi-
cally not possible, in models or in reality, to engineer
a policy that delivers the same low target rate of infla-
tion every month or quarter. The economy is hit by
any number of shocks that can move both real output
and inflation around from month to month—large
energy price movements, for example. In the pres-
ence of such shocks, a good policy might be one that,
while not hitting its inflation target each month, always
tends to move back toward its target and never stray
too far.
Complete models incorporating a modern Phillips
curve also allow economists to formalize the notion
of monetary policy credibility. Remember that
credibility refers to what people believe about the
way the central bank intends to conduct policy.
If people are uncertain about what rule best
describes the behavior of the central bank, then
they will try to learn from what they see the central
bank doing. This learning can make people’s
expectations about future policy evolve in a compli-
cated way. In general, uncertainty about the central
bank’s policy, or doubts about its commitment to low
inflation, can raise the cost (in terms of output or
employment) of reducing inflation. That is, the short-
run relationship between inflation and unemployment
depends on the public’s long-run expectations about
monetary policy and inflation.
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2006 Annual Report ■ Page 21
The modern approach embodies many features
of the earlier thinking about the Phillips curve. The
characterization of policy as a systematic pattern of
behavior employed by the central bank, providing
the framework within which people form systematic
expectations about future policy, follows the work of
Kydland and Prescott. And the focus on expectations
itself, of course, originated with Friedman. Within
this modern framework, however, some important
debates remain unsettled. While our characterization
of the framework has emphasized the forward-looking
nature of people’s expectations, some economists
believe that deviations from this benchmark are
important for understanding the dynamic behavior of
inflation. We turn to this question in the next section.
We have described here an approach that has
been adopted by many contemporary economists
for applied central bank policy analysis. But we
should note that this approach is not without its
critics. Many economists view the price-setting
frictions that are at the core of this approach as
ad hoc and unpersuasive. This critique points to the
value of a deeper theory of firms’ price-setting
behavior. Moreover, there are alternative frictions
that can also rationalize monetary non-neutrality.
Alternatives include frictions that limit the information
available to decisionmakers or that limit some
people’s participation in some markets. So while
the approach we’ve described does not represent
the only possible modern model, it has become a
popular workhorse in policy research.
How Well Does the Modern
Phillips Curve Fit the Data?
The Phillips curve began as a relationship drawn to fit
the data. Over time, it has evolved as economists’
understanding of the forces driving those data has
developed. The interplay between theory—the appli-
cation of economic logic—and empirical facts has
been an important part of this process of discovery.
The recognition of the importance of expectations
developed together with the evidence of the apparent
instability of the short-run trade-off. The modern
Phillips curve represents an attempt to study the
behavior of both inflation and real variables using
models that incorporate the lessons of Friedman,
Phelps, and Lucas and that are rich enough to pro-
duce results that can be compared to real world data.
Attempts to fit the modern, or New Keynesian,
Phillips curve to the data have come up against a
challenging finding. The theory behind the short-run
relationship implies that current inflation should
depend on current real activity, as measured by
unemployment or some other real variable, and
expected future inflation. When estimating such an
equation, economists have often found that an addi-
tional variable is necessary to explain the behavior of
inflation over time. In particular, these studies find
that past inflation is also important.23
Inflation persistence
The finding that past inflation is important for the
behavior of current and future inflation—that is, the
finding of inflation persistence—implies that move-
ments in inflation have persistent effects on future
inflation, apart from any effects on unemployment or
expected inflation. Such persistence, if it were an
inherent part of the structure and dynamics of the
economy, would create a challenge for policymakers
The short-run relationship between inflation
and unemployment depends on the public’s
long-run expectations about monetary policy
and inflation.
”
“
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Page 22 ■ Federal Reserve Bank of Richmond
to reduce inflation by reducing people’s expectations.
Remember that we stated earlier the possibility that if
the central bank could convince the public that it was
going to bring inflation down, then the desired reduc-
tion might be achieved with little cost in unemploy-
ment or output. Inherent inflation persistence would
make such a strategy problematic. Inherent persist-
ence makes the set of choices faced by the policy-
maker closer to that originally envisioned by
Samuelson and Solow. The faster one tries to bring
down inflation, the greater the real economic costs.
Inherent persistence in inflation might be thought to
arise if not all price-setters in the economy were as
forward looking as in the description given earlier. If,
instead of basing their price decisions on their best
forecast of future inflation behavior, some firms simply
based current price choices on the past behavior of
inflation, this backward-looking pricing would impart
persistence to inflation. Jordi Galíand Mark Gertler,
who took into account the possibility that the economy
is populated by a combination of forward-looking and
backward-looking participants, introduced a hybrid
Phillips curve in which current inflation depends on
both expected future inflation and past inflation.24
An alternative explanation for inflation persistence
is that it is a result primarily of the conduct of mone-
tary policy. The evolution of people’s inflation ex-
pectations depends on the evolution of the conduct of
policy. If there are significant and persistent shifts in
policy conduct, expectations will evolve as people
learn about the changes. In this explanation, inflation
persistence is not the result of backward-looking
decisionmakers in the economy but is instead the
result of the interaction of changing policy behavior
and forward-looking private decisions by households
and businesses.25
Another possibility is that inflation persistence is the
result of the nature of the shocks hitting the economy.
If these shocks are themselves persistent—that is,
bad shocks tend to be followed by more bad
shocks—then that persistence can lead to persist-
ence in inflation. The way to assess the relative
importance of alternative possible sources of persist-
ence is to estimate the multiple equations that make
up a more complete model of the economy. This
approach, in contrast with the estimation of a single
Phillips curve equation, allows for explicitly consider-
ing the roles of changing monetary policy, backward-
looking pricing behavior, and shocks in generating
inflation persistence. A typical finding is that the back-
ward-looking terms in the hybrid Phillips curve appear
considerably less important for explaining the dynam-
ics of inflation than in single equation estimation.26
The scientific debate on the short-run relationship
between inflation and real economic activity has not
yet been fully resolved. On the central question of the
importance of backward-looking behavior, common
sense suggests that there are certainly people in the
real-world economy who behave that way. Not every-
one stays up-to-date enough on economic conditions
to make sophisticated, forward-looking decisions.
People who do not may well resort to rules of thumb
that resemble the backward-looking behavior in some
economic models. On the other hand, people’s
behavior is bound to be affected by what they believe
to be the prevailing rate of inflation. Market partici-
pants have ample incentive and ability to anticipate
the likely direction of change in the economy. So both
backward- and forward-looking behavior are ground-
ed in common sense. However the more important
scientific questions involve the extent to which either
type of behavior drives the dynamics of inflation and
is therefore important for thinking about the conse-
quences of alternative policy choices.
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Page 24 ■ Federal Reserve Bank of Richmond
The importance of inflation
persistence for policymakers
Related to the question of whether forward- or back-
ward-looking behavior drives inflation dynamics is the
question of how stable people’s inflation expectations
are. The backward-looking characterization suggests
a stickiness in beliefs, implying that it would be hard
to induce people to change their expectations. If rela-
tively high inflation expectations become ingrained,
then it would be difficult to get people to expect a
decline in inflation. This describes a situation in which
disinflation could be very costly, since only persistent
evidence of changes in actual inflation would move
future expectations. Evidence discussed earlier from
episodes of dramatic changes in the conduct of policy,
however, suggests that people can be convinced that
policy has changed. In a sense, the trade-offs faced
by a policymaker could depend on the extent to which
people’s expectations are subject to change. If people
are uncertain and actively seeking to learn about the
central bank’s approach to policy, then expectations
might move around in a way that departs from the
very persistent, backward-looking characterization.
But this movement in expectations would depend on
the central bank’s actions and statements about its
conduct of policy.
The periods that Goodfriend (1993) described as
inflation scares can be seen as periods when people’s
assessment of likely future policy was changing
rather fluidly. Even very recently, we have seen
episodes that could be described as “mini scares.”
For instance, in the wake of Hurricane Katrina in late
2005, markets’ immediate response to rising energy
prices suggested expectations of persistently rising
inflation. Market participants, it seems, were uncer-
tain as to how much of a run-up in general inflation
the Fed would allow. Inflation expectations moved
back down after a number of FOMC members made
speeches emphasizing their focus on preserving low
inflation. This episode illustrates both the potential
for the Fed to influence inflation expectations and
the extent to which market participants are at times
uncertain as to how the Fed will respond to
new developments.
Making Policy
While the scientific dialogue continues, policymakers
must make judgments based on their understanding
of the state of the debate. At the Federal Reserve
Bank of Richmond, policy opinions and recommenda-
tions have long been guided by a view that the short-
term costs of reducing inflation depend on expecta-
tions. This view implies that central bank credibility—
that is, the public’s level of confidence about the central
bank’s future patterns of behavior—is an important
aspect of policymaking. Central bank credibility
makes it less costly to return inflation to a desirable
level after it has been pushed up (or down) by energy
prices or other shocks to the economy. This view of
policy is consistent with a view of the Phillips curve in
which inflation persistence is primarily a consequence
of the conduct of policy.
The evidence is perhaps not yet definitive. As out-
lined in our argument, however, we do find support
for our view in the broad contours of the history of
U.S. inflation over the last several decades. At a time
when a consensus developed in the economics
profession that the Phillips curve trade-off could be
exploited by policymakers, apparent attempts to do
so led to or contributed to the decidedly unsatisfactory
economic performance of the 1970s. And the
improved performance that followed coincided with
the solidification of the profession’s understanding of
the role of expectations. We also see the initial costs
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2006 Annual Report ■ Page 25
of bringing down inflation in the early 1980s as
consistent with our emphasis on expectations and
credibility. After the experience of the 1970s, credibili-
ty was low, and expectations responded slowly to the
Fed’s disinflationary policy actions. Still, the response
of expectations was faster than might be implied by a
backward-looking Phillips curve.
We also view policymaking on the basis of a
forward-looking understanding of the Phillips curve
as a prudent approach. A hybrid Phillips curve with
a backward-looking component presents greater
opportunities for exploiting the short-run trade-off.
In a sense, it assumes that the monetary policymaker
has more influence over real economic activity than
is assumed by the purely forward-looking specifica-
tion. Basing policy on a backward-looking formulation
would also risk underestimating the extent to which
movements in inflation can generate shifts in inflation
expectations, which could work against the policy-
maker’s intentions. Again, the experience of past
decades suggests the risks associated with policy-
making under the assumption that policy can
persistently influence real activity more than it really
can. In our view, these risks point to the importance
of a policy that makes expectational stability
its centerpiece.
Conclusion
One key lesson from the history of the relationship
between inflation and real activity is that any short-run
trade-off depends on people’s expectations for infla-
tion. Ultimately, monetary policy has its greatest
impact on real activity when it deviates from people’s
expectations. But if a central bank tries to deviate
from people’s expectations repeatedly, so as to sys-
tematically increase real output growth, people’s
expectations will adjust.
There are also, we think, important lessons in the
observation that overall economic performance, in
terms of both real economic activity and inflation, was
much improved beginning in the 1980s as compared
to that in the preceding decade. While this improve-
ment could have some external sources related to the
kinds of shocks that affect the economy, it is also
likely that improved conduct of monetary policy
played a role. In particular, monetary policy was able
to persistently lower inflation by responding more to
signs of rising inflation or inflation expectations than
had been the case in the past. At the same time, the
variability of inflation fell, while fluctuations in output
and unemployment were also moderating.
We think the observed behavior of policy and
economic performance is directly linked to the
lessons from the history of the Phillips curve. Both
point to the importance of the expectational con-
sequences of monetary policy choices. An approach
to policy that is able to stabilize expectations will be
most able to maintain low and stable inflation with
minimal effects on real activity. It is the credible main-
tenance of price stability that will in turn allow real
economic performance to achieve its potential over
the long run. This will not eliminate the business cycle
since the economy will still be subject to shocks that
quicken or slow growth. We believe the history of the
Phillips curve shows that monetary policy’s ability to
add to economic variability by overreacting to shocks
is greater than its ability to reduce real variability,
once it has achieved credibility for low inflation.
An approach to policy that is able to stabilize
expectations will be most able to maintain low
and stable inflation with minimal effects on real
activity.
”
“
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Page 26 ■ Federal Reserve Bank of Richmond
Endnotes
1. King and Plosser (1984).
2. Cooley and Hansen (1989), for instance.
3. Phillips (1958).
4. Keynes (1923).
5. Samuelson and Solow (1960).
6. Ibid., p. 193.
7. Friedman (1968), p. 5.
8. Phelps (1967).
9. Lucas (1972).
10. Velde (2004) provides an excellent overview of this debate.
A nontechnical description of the major arguments can be found
in Sumo (2007).
11. Lucas (1976).
12. Kydland and Prescott (1977).
13. Sargent (1999), Cogley and Sargent (2005), and Sargent, Williams,
and Zha (2006).
14. Sargent (1986).
15. Goodfriend and King (2005).
16. Ibid.
17. Mankiw (2007).
18. Goodfriend (1993).
19. There are a number of technical assumptions needed to make
this intuitive connection precisely correct.
20. Clarida, Galí, and Gertler (1999).
21. Goodfriend and King (1997).
22. We use the term “monetary policy rule” in the very general sense of
any systematic pattern of choice for the policy instrument—the funds
rate—based on the state of the economy.
23. Fuhrer (1997).
24. Galíand Gertler (1999).
25. Dotsey (2002) and Sbordone (2006).
26. Lubik and Schorfheide (2004).
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