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Output-InflationTradeofs
By ROBERT E. LUCAS, JR.*
(~) ~ ~~~ = (1-)Pt (z) + 07Pt 4This predicted relationship between a supply elas-
ticity and the variance of a component of the price series
where 0= i2/(u2+i2) , and variance Ooa2. is analogous to the link between the income elasticity of
Combining (1), (3), and (5) yields the consumption demand and the variances of permanent
supply function for market z: and transitory income components which Friedman
(1957) observes. As will be seen in Section II, it works
- PTt]
yt(Z) = Ynt + O@Y[Pt(z) in empirical testing in much the same way as well.
(6) This particular characterization of the "shocks" to
+ XYc,t-1(z) the economy is not central to the theory, but to discuss
VOL. 63 NO. 3 LUCAS: OUTPUT-INFLATIONTRADEOFF 329
immediate effect on prices is one minus the a fitted trend line must average to zero.
real output effect, with the remainder of Accordingly, we must base tests of the
the impact coming in the succeeding pe- natural rate hypothesis (in this context)
riod. We note in particular that this lag on (13): a relationship between an ob-
pattern may well produceperiods of simul- servable variance and a slope parameter.
taneous inflation and below average real
output. Though these periods arise be- II. Test Results
cause of supply shifts, the shifts result Testing the hypothesis advanced above
from lagged perceptionof demand changes, involves two steps. First, within each
and not from autonomous changes in the country (11) and (12) should perform
cost structure of suppliers. reasonably well. In particular, under the
In addition to these features, the model presumption that demand fluctuations are
does indeed assert the existence of a nat- the major source of variation in APt and
ural rate of output: the averagerate of de- yct, the fits should be "good." The esti-
mand expansion, 5, appears in (11) with a mated values of 7rand X should be between
coefficient equal in magnitude to the co- zero and one. Finally, since (11) and (12)
efficient of the current rate, and with the involve five slope parametersbut only two
opposite sign. Thus changes in the average theoretical ones, the estimated ir and X
rate of nominal income growth will have no values obtained from fitting (11) should
effect on average real output. On the other work reasonably well in explaining varia-
hand, unanticipated demand shifts do tions in APt.
have output effects, with magnitude given The main object of this study, however,
by the parameter ir. Since this effect de- is not to "explain" output and price level
pends on "fooling" suppliers (in the sense movements within a given country, but
of subsectionA), one expects that 7rwill be rather to see whether the terms of the
larger the smaller the variance of the output-inflation "tradeoff'' vary across
demand shifts. We next develop this im- countries in the way predicted by the nat-
plication explicitly. ural rate theory. For this purpose, we shall
From the definition of ir in terms of 0 utilize the theoretical relationship (13)
and y, and the definition of 6 in terms of and the estimated values of r and a'2.
q2 and r2 we have Under the assumption that r2 and y are
relatively stable across countries, the esti-
r27 mated r values should decline as the sam-
a2 + r2(1 + y) ple variance of Axt increases.
Descriptive statistics for the eighteen
Combining with the expression for u2 ob-
tained above, this gives countries in the sample are given in Table
1., As is evident, there is no association
(13) *,
r =-
(1
8 The raw data on real and nominal GNP are from
- )2a2 + r2(1 + y)
Yearbookof National Accounts Statistics, where series
from many countries are collected and put on a uniform
For fixed r2 and y, then, ir takes the value basis. The choice of countries is by no means random:
y/(1 +y) at ax= 0 and tends monotonically the eighteen used are all the countries from which con-
tinuous series are available. The sample could thus be
to zero as o2 tends to infinity. broadened considerably by use of sources from indi-
The prediction that the average devia- vidual countries. To obtain the variables used in the
tion of output from trend, E(y,,), is in- tests, the logs of real and nominal output, Ytand xt, are
logs of the series in the source. The log of the price level,
variant under demand policies is not, of
Pt, is the difference xt-yt; yt is the residual from the
course, subject to test: the deviations from trend line yt= a+bt, fit by least squares from the sample
VOL. 63 NO. 3 LUCAS: OUTPUT-INFLATIONTRADEOFF 331
TABLE1-DESCRIPTIVESTATISTICS,
1952-67
between average real growth rates and and Puerto Rico, so do the estimated X
average rates of inflation: this fact seems values. The R's indicate that for many, or
to be consistent with both the conventional perhaps most countries, important out-
and natural rate views of the tradeoff. put-determiningvariables have been omit-
Since our interest is in comparingreal out- ted from the model. The R s for the infla-
put and price behavior underdifferenttime tion rate equation, (12), are given in
patterns of nominal income, these statistics column (4) of Table 2. In general, these
are somewhat disappointing. Essentially tend to be lower than for equation (11),
two types of nominal income behavior are and not surprisingly the estimated co-
observed:the highly volatile and expansive efficients from (12) (which are not shown)
policies of Argentina and Paraguay, and tend to behave erratically. Column (5) of
the relatively smooth and moderately ex- Table 2 gives the fraction of the variance
pansive policies of the remaining sixteen of AP' explained by (12) when the co-
countries. But if the sample provides only efficient estimates from (11) are imposed.
two "points," they are indeed widely (A "-" indicates a negative value.)9
separated: the estimated variance of de- With respect to its performance as an
mand in the high inflation countries is on intracountry model of income and price
the order of 10 times that in the stable determination, then, the system (11)-(12)
price countries. passes the formal tests of significance. On
The first three columns of Table 2 sum- the other hand, the goodness-of-fit statis-
marize the performance of equation (11)
in accounting for movements in yet. The 9 The loss of explanatory power when these coeffi-
estimated values for ir all lie between zero cients are imposed on (12) can be assessed formally by
an approximate Chi-square test. By this measure, the
and one; with the exceptions of Argentina loss is significant at the .05 level for Paraguay only. As
Table 2 shows, however, this test is somewhat decep-
period. The moments given in Table 1 are maximum tive: for several countries the least squares estimates of
likelihood estimates based on these series. The estimates (12) are so poor that there is little explanatory power to
reported in Table 2 are by ordinary least squares. lose, and the test is "passed" vacuously.
332 THE AMERICAN ECONOMIC REVIEW JUNE 1973
Country 7r R R2 R2
tics are generally considerably poorer than tina. For the United States, the fitted ver-
we have come to expect from annual time- sions of (11) and (12) are:
series models.
yct = - .049 + (.910),Axt + (.887)yc,t-l
In contrast to these somewhat mixed re-
sults, the behavior of the estimated 7r APt = - .028 + (.119) Axt + (.758) Axt_
values across countries is in striking con- -
(.637) Aycet_1
formity with the natural rate hypothesis. The comparable results for Argentina are:
For the sixteen stable price countries, *
ranges from .287 to .910; for the two yct = - .006 + (.011)Axt - (.126)y,.,t_j
volatile price countries, this estimate is APt = - .047 + (1.140)Axt - (.083) Axt-
smaller by a factor of 10! To illustrate this
+ (.102)Ayc,t-1
order-of-magnitude effect more sharply,
let us examine the complete results for two In a stable price country like the United
countries: the United States and Argen- States, then, policies which increase nomi-
VOL. 63 NO. 3 LUCAS: OUTPUT-INFLATION TRADEOFF 333
nal income tend to have a large initial first, that changes in average inflation
effect on real output, together with a small, rates will not increase average output, and
positive initial effect on the rate of infla- secondly, that the higher the variance in
tion. Thus the apparent short-term trade- average prices, the less "favorable" will be
off is favorable, as long as it remains un- the observed tradeoff.
used. In contrast, in a volatile price The most natural cross-national com-
country like Argentina, nominal income parison of these propositions would seem
changes are associated with equal, con- to be a direct examination of the associa-
temporaneous price movements with no tion of average inflation rates and average
discernible effect on real output. These output, relative to "normal" or "full em-
results are, of course, inconsistent with the ployment." Unfortunately, there seems to
existence of even moderately stable Phillips be no satisfactory way to measure normal
curves. On the other hand, they follow output. The deviation-from-fitted-trend
directly from the view that inflation method I have used defines normal output
stimulates real output if, and only if, it to be average output. The use of unem-
succeeds in "fooling" suppliers of labor ployment series suffers from the same diffi-
and goods into thinking relative prices are culty, since one must somehow select the
moving in their favor. (obviously positive) rate to be denoted full
employment.
III. Concluding Remarks Thus although the issue revolves around
The basic idea underlying the tests re- the relation between means of inflation
ported above is extremely simple, yet I am and output rates, it cannot be resolved by
afraid it may have become obscured by the examination of sample averages. Fortu-
rather special model in which it is em- nately, the existence of a stable tradeoff
bodied. In this section, I shall try to re- also implies a relationship between vari-
state this idea in a way which, though not ances of inflation and output rates, as
quite accurate enough to form the basis for illustrated in Figure 1. With a stable
econometric work, conveys its essential tradeoff, policies which lead to wide varia-
feature more directly. tion in prices must also induce comparable
The propositions to be compared empiri- variation in real output.' If these sample
cally refer to the effects of aggregate de- variances do not tend to move together
mand policies which tend to move infla- (and, as Table 1 shows, they do not) one
tion rates and output (relative to trend) in
the same direction, or alternatively, un-
employment and inflation in opposite APt'
directions. The conventional Phillips curve Var(yct) 'a2 Varf(APt) 0 0
account of this observed co-movement says
that the terms of the tradeoff arise from 00
relatively stable structural features of the 0
economy, and are thus independent of the
nature of the aggregate demand policy
pursued. The alternative explanation of
0 Stable Price Country
the same observed tradeoff is that the 0 Volatile Price Country
positive association of price changes and
output arises because suppliers misinter-
pret general price movements for relative Yct
price changes. It follows from this view, FIGURE 1
334 THE AMERICAN ECONOMIC REVIEW JUNE 1973
can only conclude that the tradeoff tends trality of Money," J. Econ. Theor., Apr.
to fade away the more frequently it is 1972, 4, 103-24.
used, or abused. , "EconometricTesting of the Natural
This simple argument leads to a formal Rate Hypothesis," Conferenceon the Econ-
test if the output-inflation association is ometrics of Price Determination, Washing-
ton 1972, 50-59.
entirely contemporaneous. In fact, how-
and L. A. Rapping, "Real Wages,
ever, it involves lagged effects which make Employment and the Price Level," J. Polit.
a direct comparison of variances, as just Econ., Sept./Oct. 1969, 77, 721-54.
suggested, difficult in short time-series. _ and , "Unemployment in the
Accordingly, it has been necessary to im- Great Depression: Is There a Full Expla-
pose a specific, simple structure on the nation?",J. Polit. Econ., Jan./Feb. 1972, 80,
data. As we have seen, this structure ac- 186-91.
counts for output and inflation rate move- J. F. Muth, "Rational Expectations and the
ments only moderately well, but well Theory of Price Movements," Economet-
enough to capture the main phenomenon rica, July 1961, 29, 315-35.
predicted by the natural rate theory: the E. S. Phelps, introductory chapter in E. S.
higher the variance of demand, the more Phelps et al., Micro-economics of Inflation
unfavorable are the terms of the Phillips and Employment Theory, New York 1969.
F. Raines, "MacroeconomicDemand and Sup-
tradeoff.
ply: an Integrative Approach," Washing-
ton Univ. working paper, Apr. 1971.
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M. Friedman, A Theory of the Consumption J. Polit. Econ., Mar./Apr. 1970, 78, 306-10.
Function, Princeton 1957. P. Taubman and M. Wilkinson, "User Cost,
, "The Role of Monetary Policy," Capital Utilization and Investment
Amer. Econ. Rev., Mar. 1968, 58, 1-17. Theory," Int. Econ. Rev., June 1970, 11,
D. F. Gordon and A. Hynes, "On the Theory 209-15.
of Price Dynamics," in E. S. Phelps et al., United Nations, Department of Economic
Micro-economics of Inflation and Employ- and Social Affairs, United Nations Statisti-
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R. E. Lucas, Jr., "Expectations and the Neu- Statistics, 66 and 68, New York 1958.