Working Paper: NBER ID: w19267
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: Natural Rate Hypothesis; Animal Spirits; Belief Function; Macroeconomics
JEL Codes: E0; E24; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| natural rate hypothesis (NRH) does not hold in the data (E19) | high unemployment can persist as an equilibrium (J64) |
| animal spirits (E32) | economic outcomes (F61) |
| belief function (D83) | expectations about future economic conditions (E66) |
| expectations about future economic conditions (E66) | current economic behavior (E70) |
| incorrect expectations (D84) | deviations from the natural rate hypothesis (NRH) (E19) |
| belief function (D83) | persistence of unemployment (J64) |
| animal spirits (E32) | deviations from the natural rate hypothesis (NRH) (E19) |