The Natural Rate Hypothesis: An Idea Past its Sell-By Date
15 Pages Posted: 1 Aug 2013
Date Written: August 2013
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.
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