Some intranational evidence on output-inflation tradeoffs

In a seminal paper, Lucas (1973) provided the theoretical relationship between aggregate demand and real output based on relative price confusion at the individual market level. Ball, Mankiw, and Romer (BMR, 1988) derive the same relation using a New Keynesian framework. Even though both theories predict a positive relationship between nominal shocks and cyclical movements in real output, they are distinguished by two notable differences. First, according to New Keynesian theory, nominal shocks have a smaller effect on real output for high inflation countries since prices are adjusted more frequently. Lucas' model has no implication for the level of inflation. Second, according to New Keynesian theory, a higher variance of relative prices, and hence an increase in uncertainty, will lead to a smaller effect of nominal shocks on real output since prices are set for shorter periods and adjusted more frequently. Lucas' model, however, makes the exact opposite prediction since a high variance of relative prices leads to more confusion in the market level equilibrium. By emphasizing the first implication of the New Keynesian theory, BMR obtain strong evidence supporting their model using international data. ; In this paper we concentrate on the second difference between the New Keynesian theory and Lucas' model which, we believe, distinguishes one from the other more clearly. We derive the individual market level equilibrium relationship as well as the aggregate level one for the Lucas model. We demonstrate, similarly to BMR, that both the Lucas model and New Keynesian models make similar predictions for the response between nominal and real variables, even at the disaggregate level. ; We estimate, using cross-sectional data for the U.S., the crucial parameters of the relationship between aggregate nominal demand shocks and real output. The data we use to estimate the market level model are nominal and real output, and inflation for 50 states plus the District of Columbia at the annual frequency over the time period 1977-1991. The regression results suggest that the model provides a good fit of the data at the state level. However, we find strong support for New Keynesian theory in that an increase in the variance of relative prices across states leads to a smaller effect of demand shocks on real output. We conclude that the Lucas model omits New Keynesian features of intranational data.