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The Natural Rate Hypothesis: An idea past its sell-by date

  • Roger E.A. Farmer

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.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 19267.

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Date of creation: Aug 2013
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Publication status: published as Farmer, Roger, 2013. "The Natural Rate Hypothesis: an idea past its sell-by date," Bank of England Quarterly Bulletin, Bank of England, vol. 53(3), pages 244-256.
Handle: RePEc:nbr:nberwo:19267
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  1. Beyer, Andreas & Farmer, Roger E.A., 2007. "Natural rate doubts," Journal of Economic Dynamics and Control, Elsevier, vol. 31(3), pages 797-825, March.
  2. Robert E. Hall & Paul R. Milgrom, 2008. "The Limited Influence of Unemployment on the Wage Bargain," American Economic Review, American Economic Association, vol. 98(4), pages 1653-74, September.
  3. Mark Gertler & Antonella Trigari, 2009. "Unemployment Fluctuations with Staggered Nash Wage Bargaining," Journal of Political Economy, University of Chicago Press, vol. 117(1), pages 38-86, 02.
  4. Olivier J. Blanchard, 1986. "Hysteresis and Unemployment," Working papers 430, Massachusetts Institute of Technology (MIT), Department of Economics.
  5. Long, John B, Jr & Plosser, Charles I, 1983. "Real Business Cycles," Journal of Political Economy, University of Chicago Press, vol. 91(1), pages 39-69, February.
  6. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, vol. 50(6), pages 1345-70, November.
  7. Modigliani, Franco, 1977. "The Monetarist Controversy or, Should We Forsake Stabilization Policies?," American Economic Review, American Economic Association, vol. 67(2), pages 1-19, March.
  8. Frank Smets & Raf Wouters, 2007. "Shocks and Frictions in US Business Cycles : a Bayesian DSGE Approach," Working Paper Research 109, National Bank of Belgium.
  9. Luca Sala & Antonella Trigari & Mark Gertler, 2007. "An Estimated Monetary DSGE Model with Unemployment and Staggered Nominal Wage Bargaining," 2007 Meeting Papers 353, Society for Economic Dynamics.
  10. Milton Friedman, 1971. "A Theoretical Framework for Monetary Analysis," NBER Books, National Bureau of Economic Research, Inc, number frie71-1, September.
  11. Lucas, Robert E, Jr, 1978. "Unemployment Policy," American Economic Review, American Economic Association, vol. 68(2), pages 353-57, May.
  12. Merz, Monika, 1995. "Search in the labor market and the real business cycle," Journal of Monetary Economics, Elsevier, vol. 36(2), pages 269-300, November.
  13. Robert E. Hall, 2005. "Employment Fluctuations with Equilibrium Wage Stickiness," American Economic Review, American Economic Association, vol. 95(1), pages 50-65, March.
  14. Roger Farmer & Carine Nourry & Alain Venditti, 2014. "The Inefficient Markets Hypothesis: Why Financial Markets Do Not Work Well in the Real World," 2014 Meeting Papers 516, Society for Economic Dynamics.
  15. P. Diamond, 1980. "Aggregate Demand Management in Search Equilibrium," Working papers 268, Massachusetts Institute of Technology (MIT), Department of Economics.
  16. Howitt, Peter & McAfee, R Preston, 1987. "Costly Search and Recruiting," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 28(1), pages 89-107, February.
  17. Andolfatto, David, 1996. "Business Cycles and Labor-Market Search," American Economic Review, American Economic Association, vol. 86(1), pages 112-32, March.
  18. Kerry A. Pearce & Kevin D. Hoover, 1995. "After the Revolution: Paul Samuelson and the Textbook Keynesian Model," History of Political Economy, Duke University Press, vol. 27(5), pages 183-216, Supplemen.
  19. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April.
  20. Mortensen, Dale T, 1970. "Job Search, the Duration of Unemployment, and the Phillips Curve," American Economic Review, American Economic Association, vol. 60(5), pages 847-62, December.
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