1. 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 that we constructed in the lectures, being sure to label 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).

1. 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. 

NAIRU                                                                                                  GDP Growth

PGE                                                                                                        Inflation PCE core

Unemployment Rate                                                                     Inflation PCE

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

True/ False (40 points total – 2 points each)

1)      According to the “We are all Keynesians Now” article, the labor secretary at that time wanted the unemployment rate to fall down to 3%.

2)      The misery index in 1980 exceeded 25.

3)      The mid to late 1970s was the ‘heyday’ of Keynesian economics in the US economy.

4)      Keynes believed that it was the responsibility of the government to use its powers to increase production, incomes and jobs.

5)      Consistent with his thought on spending heavily, Keynes was known as an excellent tipper.

6)      The steeper the SRAS curve, the steeper the short-run Phillips curve.

7)      If the long-run aggregate supply curve is vertical so is the long-run Phillips curve.

8)      Friedman and Phelps agreed that there is a trade-off between unemployment and inflation, but only in the long run.

9)      If actual inflation is lower than expected inflation, then the actual real wage is higher than the expected real wage. This being the case, firms will lay off workers.

10)   According to the Taylor Rule described in the lectures, if the Fed is getting an A+, then the federal funds rate should be set at 5%

11)   According to the Taylor principle, if actual inflation rises by 1% over target inflation, then the Fed should raise the federal funds rate by 2% to make sure that the real federal funds rate rises which is referred to as “leaning against the wind.

12)   If the actual federal funds rate is higher than the funds rates implied by the Taylor rule, then we say that the central bank is hawkish.

13)   If actual inflation rises one percent above target and the central bank raises the actual funds rate by one percent then according to the Taylor rule, the central bank is being hawkish.

14)    According to the Taylor rule, the Greenspan Fed was hawkish during the new economy years.

15)   According to the Taylor rule, the Greenspan Fed was hawkish during the job-less recovery as well as the job-loss recovery.

16)   One way to explain the apparent tradeoff between inflation and unemployment during the 1960s, expected inflation was consistently higher than the actual inflation implying that firms would be willing to higher more workers given this difference between expected and actual inflation. The result therefore would be higher inflation and lower unemployment, consistent with the facts during the 1960s.

17)   We argued that the modified version of the Taylor rule during the jobless recovery following the 1990 – 1991 recession explained Greenspan and the Fed’s behavior much better than the original Taylor Rule.

18)   According to the Phillips curve analysis, if expected inflation is equal to actual inflation then we are at NAIRU. However, if actual inflation is higher than expected, then the actual unemployment rate will be higher than that associated with NAIRU.

19)   If firms and workers had perfect foresight as to inflation so that actual = expected inflation at all times, then the Phillips curve would be vertical and thus, there would be no trade between unemployment and inflation, even in the short run.

20)   We argued that a federal funds rate target of 4% is consistent with the stance of monetary policy being neutral as in neither tight nor loose.