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



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