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Phillips curve theory.
Phillips curve theory indicates that changes in inflation
are influenced by the state of the economy relative to its productive capacity,
as well as to other factors. This productive capacity can be measured by poten-
tial GDP, which is a function of the natural rate of unemployment, the rate of
unemployment consistent with full employment. A related concept is the
NAIRU
, the
nonaccelerating inflation rate of unemployment,
the rate of
unemployment at which there is no tendency for inflation to change.
5
Simply
put, the theory states that when the unemployment rate is above NAIRU with
output below potential, inflation will come down, but if it is below NAIRU with
output above potential, inflation will rise. Prior to 1995, the NAIRU was thought
to reside around 8%. However, with the decline in unemployment in the late
1990s, with no increase in inflation and even a slight decrease, some critics have
questioned the value of Phillips curve theory. Either they claim that it just doesn t
work any more or alternatively believe that there is great uncertainty about the
value of NAIRU. Phillips curve theory is now highly controversial, and many
economists believe that it should not be used as a guide for the conduct of
monetary policy.
As Figure 18-5 shows, the Taylor rule does a pretty good job of describing the
Bank of Canada s setting of the overnight rate. Does this mean that the Bank of
Canada should fire all its economists and put a computer in charge that just has to
compute the Taylor rule setting for the overnight interest rate? This would certainly
save taxpayers a lot of money.
There are several reasons why the answer is no. First, monetary policy has long
lags, that is, it takes a long time for policy actions to affect the economy. Therefore,
monetary policy necessarily needs to be forward looking. Good monetary policy
requires that the Bank of Canada forecast where inflation and economic activity
are going to be in the future, and then adjust the policy instrument accordingly.
The Bank of Canada will therefore look at a much wider range of information than
just the current inflation rate and output gap in setting policy, as is done in the
Taylor rule. Second, no one really knows what the true model of the economy is.
Monetary policymakers therefore need to apply a lot of judgement in deciding
what the appropriate stance of monetary policy should be. In other words, the
conduct of monetary policy is as much an art as it is a science. The Taylor rule
leaves out all the art, and so is unlikely to produce the best monetary policy out-
comes. Third, the economy is changing all the time, so the Taylor rule coefficients
would be unlikely to stay constant. Fourth, financial crises such as the recent
5
There are, however, subtle differences between the two concepts, as is discussed in Arturo Estrella
and Frederic S. Mishkin, The Role of NAIRU in Monetary Policy: Implications of Uncertainty and Model
Selection, in
Monetary Policy Rules
, ed. John Taylor (Chicago: University of Chicago Press, 1999):
405 430.
subprime meltdown may require very different monetary policy, because changes
in credit spreads may alter the relationship between the overnight rate and other
interest rates more relevant to investment decisions, and therefore to economic
activity. The bottom line is that putting monetary policy on autopilot with a Taylor
rule with fixed coefficients would be a bad idea.
Given the above reasons, it is no surprise that the Taylor rule does not explain
all the movements in the overnight rate shown in Figure 18-5. For this reason,
financial institutions hire central bank watchers, as described in the Inside the
Central Bank box, Bank of Canada Watching. The Taylor rule is, however, useful
as a guide to monetary policy. If the setting of the policy instrument is very differ-
ent from what the Taylor rule suggests, then policymakers should ask whether
they have a good reason for deviating from this rule. If they don t, then they might
be making a mistake.
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