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

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).

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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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