DP9580 The Natural Rate Hypothesis: An idea past its sell-by-date

Author(s): Roger E A Farmer
Publication Date: August 2013
Keyword(s): inflation, natural rate hypothesis, unemployment
JEL(s): E00, E24, E58
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9580

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.