By Roger E A Farmer (UCLA).
The views expressed in this article are those of the author and do not represent those of the Bank or the Monetary Policy Committee.
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). In this paper Roger Farmer reviews a body of work, published over the past decade, in which the author argues that the NRH does not hold in the data and provides an alternative paradigm that explains why it does not hold. Professor Farmer replaces the NRH with the assumption that the animal spirits of investors are a fundamental of the economy that can be modelled by a ‘belief function’. He shows how to operationalise that idea by constructing an empirical model that outperforms the New Keynesian Phillips Curve.