## In the late 1960s, Milton Friedman and Edmund Phelps

## In the late 1960s, Milton Friedman and Edmund Phelps

In the

late 1960s, Milton Friedman and Edmund Phelps argued that there was not a

structural relationship between inflation and unemployment rates. In particular, the trade off could only

exist in the short -run.

a)

(10 points) The tradeoff

between unemployment and inflation was much discussed throughout the 1960s as

there appeared to be a clear tradeoff between unemployment and inflation. In fact, we traced out the Phillips curve

beginning in the early 1960s and continuing through the end of the decade. In the space below, recreate the Phillips

curve, being sure to label the diagram completely. At minimum, you should have unemployment /

inflation combinations for 1961, 1962, 1964, 1966, and 1969. Connect the dots and we have the tradeoff

between unemployment and inflation during the 1960s, aka, the Phillips curve.

b)

(10 points) Now explain why the

Phillips curve that you constructed can only be a short-run phenomenon at

best. In particular, explain exactly

why, as we went through the decade of the 1960s, we continuously move up and to

the northwest along the Phillips curve…. from relatively high rates of

unemployment and low inflation to relatively low rates of unemployment and high

rates of inflation. In your answer, make

sure discuss the short run aspect of this curve and why, in the long-run, the

Phillips curve is vertical (hint: expected inflation, unexpected inflation,

actual real wages, and expected real wages should be a big part of your

explanation).

In this

question, we are going dig deeper into the Taylor Rule and it variants

(modifications). You will need the

following links to answer the following questions. Note, each link takes you to a page

where right above the graph on left, there is a “download data in

graph” tab – click on it and that will give you access to the data

you need.

.stlouisfed.org/fred2/graph/?g=gkU”>NAIRU .stlouisfed.org/fred2/graph/?g=gkF”>GDP Growth

.stlouisfed.org/fred2/graph/?g=gkA”>PGE .stlouisfed.org/fred2/graph/?g=gkG”>Inflation PCE core

.stlouisfed.org/fred2/graph/?g=gkB”>Unemployment Rate .stlouisfed.org/fred2/graph/?g=gkE”>Inflation PCE

.stlouisfed.org/fred2/graph/?g=gkI”>Effective Federal

Funds Rate

As Taylor assumed, we assume the

equilibrium real rate of interest, r* = 2% and the optimal inflation rate, the

target inflation rate is also equal to 2%.

a)

(10 points) Using the

‘standard’ Taylor rule with Inflation PCE (not the core), and using end of 2011

data (2011-10-01) what is the federal funds rate implied by the ‘standard’

Taylor Rule? According to the actual

federal funds rate (use the Effective Federal Funds Rate), is the Fed being

hawkish or dovish? Explain.

b)

(10 points) Repeat part a)

using the modified version of the Taylor using the unemployment gap instead of

the GDP gap just like we did in the lectures.

Also, use the PCE core rate of inflation instead of overall inflation

like you used above – the Fed arguably cares more about core inflation than

overall inflation. According to the

actual federal funds rate (use the Effective Federal Funds Rate), is the Fed

being hawkish or dovish? Which

“Taylor” rule explains Fed behavior better, the original or the

modified Taylor Rule? Explain.

c)

(10 points) Let’s go back in

time to the fourth quarter of 1965 (1965-10-01) when the “We are all

Keynesians” was featured in Time magazine.

We argued that this was heyday of Keynesian economics so we would expect

to get dovish results. Using the

original Taylor Rule that you used in part a) and the modified Taylor Rule that

you used in part b), prove that the Fed was dovish according to both versions

of the Taylor Rule.

d)

(10 points) We now go back to

the Volcker period where he was known as being a hawk on inflation. Using the data from the second quarter of

1982 (1982-04-01), prove that the Volcker Fed was hawkish according to both

versions of the Taylor Rule

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