A null Hypothesis of the Unrmployment Rate vis-?-vis the Inflation Rate in Israel; An Empirical Examination, 1990-98

Ever since the seminal paper by Friedman (1968) and Phelps (1967), the natural rate hypothesis has occupied a pivotal position in macroeconomics. This hypothesis states that only unexpected changes in the rate of inflation affect real variables such as unemployment and real output. In its rational expectations version, developed by Lucas (1972,1973), the hypothesis implies that policy makers should ignore any temporary tradeoffs and strive only for low inflation. Other economists, such as Ball (1997) and Romer and Romer (1994) argue that for a variety of reasons (the nature of labor markets, menu costs, hysteresis, etc.) tight monetary policies, aimed at reducing inflation, can also have a lasting effect on employment and output. There have been numerous empirical tests of the natural rate hypothesis1, although a problem common to virtually all of them is the lack of a reliable measure of inflationary expectations. As a result of this problem, one is always faced with the difficulty of disentangling the results of a joint hypothesis – that expected inflation does not have any real effects and that inflationary expectations are formed in one way or another. The purpose of this paper is to test the naturality hypothesis by using market extracted inflationary expectations from Israeli data. As is argued below, these expectations enable one to conduct a better test of the natural rate hypothesis than the usual alternatives. These expectations are derived from the yields of nominal and CPI linked bonds of identical maturities. Such bonds are traded regularly on the Tel-Aviv stock exchange. The paper is organized as follows: in section 2 we discuss the advantages of using the market extracted inflationary expectations. Section 3 describes the data. Section 4 describes the econometric approach and presents the empirical results. Section 5 provides a brief conclusion.