Working Paper: CEPR ID: DP9580
Authors: Roger E. A. Farmer
Abstract: Central banks throughout the world predict inflation with new-Keynesian models where, after a shock, the unemployment rate returns to its so called 'natural rate?. That assumption is called the Natural Rate Hypothesis (NRH). This paper reviews a body of work, published over the last decade, which is critical of the NRH. I argue that the NRH does not hold in the data and I provide an alternative paradigm that explains why it does not hold. I replace the NRH with the assumption that the animal spirits of investors are a fundamental of the economy and I show how to operationalize that idea by constructing an empirical model that outperforms the new-Keynesian Phillips curve. I model animal spirits with a new fundamental that I call the belief function.
Keywords: inflation; natural rate hypothesis; unemployment
JEL Codes: E00; E24; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| investor sentiment (animal spirits) (G41) | economic outcomes (inflation and unemployment) (E24) |
| assumptions underpinning the NRH (R20) | observed dynamics of inflation and unemployment (E31) |