Laurence M. Ball

English

Research Papers in Economics

FEDERAL RESERVE BANK OF ST. LOUIS REVIEW MARCH/APRIL, PART 2  2005 263
Commentary
Laurence M. Ball
MIT in the 1960s, plus the fact that I
haven’t learned much since then.
I think Meyer’s assessment of post-1979
research is on target—especially for research on
the unemployment-inflation trade-off, or Phillips
curve. As Marvin points out, this trade-off is
central to the challenges facing monetary policy.
In my opinion, the Phillips-curve research that
Marvin discusses has little practical value.
Theory Before 1979
Let me give my take on the history of thought.
I agree with Marvin that economists were con-
fused during the 1960s. They believed in a long-
run trade-off between output and inflation. They
also advanced nonmonetary theories of inflation.
For example, some suggested that inflation was
caused by greedy firms and labor unions, whose
behavior could not be controlled by the Fed (see
Nelson, 2004). 
Fortunately, a genius arrived on the scene:
Milton Friedman. Friedman cleared away confu-
sion. He repeatedly explained to us that “inflation
is always and everywhere a monetary phenome-
non.” In 1968, he explained that the output-
inflation trade-off exists only in the short run; in
the long run, unemployment must gravitate to its
natural rate.
Friedman’s views were controversial at first,
but they were soon absorbed into mainstream
thinking. By 1979, U.S. policymakers had learned
Friedman’s main lessons. The Fed deserves credit
for taking only 11 years to apply cutting-edge
theory from 1968. (By contrast, David Ricardo
explained the benefits of free trade in 1817, and
policymakers are still having trouble grasping
his point.)
T
he conference organizers asked Marvin
Goodfriend to survey current main-
stream thought on monetary policy.
Marvin has done this job very well.
I agree with parts of Marvin’s paper
(Goodfriend, 2005), such as his discussion of
explicit interest rate targeting. However, I disagree
with many of the paper’s major ideas. These ideas
are not just Marvin’s; they are part of the current
consensus among central bankers and economists.
In my opinion, this consensus is flawed.
I will organize my discussion around two
related questions. First, what has economic the-
ory since 1979 contributed to practical monetary
policy? Second, why has Federal Reserve policy
been successful since 1979? In particular, in what
ways has the Fed performed better than other
central banks?
THE CONTRIBUTIONS OF 
POST-1979 THEORY
One of Marvin’s themes is that monetary
theory has been “revolutionized” since 1979.
Advances in theory have led to great improve-
ments in real-world policy.
This view is common, but it is not universal.
A wise man from St. Louis, Laurence Meyer, has
a different opinion. In remarks at a National
Bureau of Economic Research conference, Meyer
revealed his view of the practical usefulness of
post-1979 research.
People ask me what accounts for my
success as an economist and economic
forecaster, such as it is. I tell them it’s
everything I learned in graduate school at
Laurence M. Ball is a professor at The Johns Hopkins University.
Federal Reserve Bank of St. Louis Review, March/April 2005, 87(2, Part 2), pp. 263-68.
© 2005, The Federal Reserve Bank of St. Louis.Friedman didn’t just state general principles
about the economy. His address to the American
Economic Association also included a precise
theory of the Phillips curve. It was presented in
two famous sentences:
[T]here is always a temporary trade-off
between inflation and unemployment;
there is no permanent trade-off. The tem-
porary trade-off comes not from inflation
per se, but from unanticipated inflation,
which generally means, from a rising rate
of inflation. (Friedman, 1968)
Friedman expressed his theory verbally, but we
can easily translate it into equations. Friedman’s
relation between unemployment and surprise
inflation is captured by the expectations-
augmented Phillips curve:
,
where U* is the natural rate of unemployment.
The equivalence of unanticipated inflation and
rising inflation means expectations are backward-
looking:
.
Plugging this equation into the previous one
yields the “accelerationist” Phillips curve:
.
This equation relates unemployment to the
change in inflation.
Thirty-seven years after Friedman wrote, his
Phillips curve is still the best simple theory of
the unemployment-inflation trade-off.
Research Since 1979
Marvin argues that monetary theory has
advanced greatly since 1979. What are the
advances? “On the theory side,” Marvin says,
“the introduction of rational expectations was
decisive.” More specifically, rational expectations
imply a key role for central banks’ “credibility”
as inflation fighters. In rational expectations
models, an increase in credibility shifts the 
output-inflation trade-off favorably. Thus a major
goal for policymakers is to build credibility. This
=− ∏ ∏ − − α t tt UU 1 (* )
Et t t − − =∏ ∏ 1 1
= ∏− ∏ − − t t t t EU U 1 α(* )
is a theme throughout Marvin’s paper, which uses
the terms “credibility” and “credible” 33 times
(about average for a modern paper on monetary
policy).
These ideas have indeed revolutionized eco-
nomic theory, producing Nobel prizes for Robert
Lucas, Finn Kydland, and Edward Prescott, and
probably others. However, I question the useful-
ness of rational expectations models for under-
standing inflation in the real world. There are
several related reasons.
First, suppose one wants to explain the
broad history of U.S. inflation since 1979. The
accelerationist Phillips curve still seems the best
tool for this job. That is, changes in inflation are
well explained by short-run movements in unem-
ployment. The deep recession of the early 1980s
caused inflation to fall sharply. Inflation rose a
bit in the late 1980s as unemployment fell. And
inflation fell moderately during the recessions of
the early 1990s and 2000s.
If credibility were really important, one would
see shifts in inflation that are not explained by
unemployment (or obvious supply shocks). In
these episodes, changes in credibility would shift
the short-run Phillips curve. We haven’t seen such
episodes in the United States or other countries
with moderate inflation. When Sargent (1983)
looked for an example, he had to go back to France
in the 1920s—and even this case is disputed by
historians. The concept of credibility is not use-
ful for explaining the history of inflation.
Researchers have looked for credibility effects
in various ways, and most results are negative.
Some examples:
• Inflation expectations in the United States
are measured by several surveys. These
expectations consistently follow actual
inflation with a lag. Again, there are no
unusual episodes that might be explained
by credibility effects.
• In theory, greater credibility reduces the
cost of disinflation—the sacrifice ratio. In
practice, this doesn’t happen. Debelle and
Fischer (1994) find that sacrifice ratios are
higher for central banks that have a higher
level of independence, which should be
more credible. Sacrifice ratios are especially
Ball
264 MARCH/APRIL, PART 2 2005 FEDERAL RESERVE BANK OF ST. LOUIS REVIEWhigh for Germany under the Bundesbank—
probably the most credible central bank in
history. The sacrifice ratio for the U.S. dis-
inflation of 1990-94, after a decade of credi-
bility building by Volcker and Greenspan,
was high compared with previous U.S.
disinflations (Zhang, 2001).
• Over the past 15 years, many central banks
have adopted inflation targeting. Their
stated objectives include greater credibility
and anchored inflation expectations. How-
ever, cross-country comparisons produce
little evidence that inflation targeting
changes the behavior of output or inflation
(Ball and Sheridan, 2005).
The “New Synthesis” Model
In the past decade, many researchers have
converged on a specific model of the economy.
Marvin accurately calls it the “modern consen-
sus model.” It is sometimes called the “New
Neoclassical Synthesis” and sometimes the “New
Keynesian Synthesis”— the model is so hot that
the Keynesians and Classicals fight over who gets
credit for it.
As Marvin discusses, the model is “a dynamic
general equilibrium model with a real business
cycle core and costly nominal price adjustment.”
Specifically, the model uses the Taylor/Calvo spec-
ification of staggered price setting. The model pro-
duces the following version of the Phillips curve:
.
This equation is the centerpiece of the New
Synthesis model.
The New Synthesis model has strong micro-
foundations. The derivation of the Phillips curve
is simple and elegant. It is easy to see why so many
graduate students use this model in their disser-
tations. However, for the purposes of monetary
policy, the model has a problem: It is wildly
counterfactual.
Mankiw (2001) provides the definitive
debunking of the New Synthesis model. He shows
that, in the model, a monetary contraction that
reduces inflation also causes an output boom.
This result is the opposite of the common empir-
= ∏ − ∏ − + EU U t tt t α 1 (* )
ical finding that disinflations cause recessions.
The source of the theoretical result is a bit subtle:
It involves the fact that the Phillips curve includes
current expectations of future inflation, not past
expectations of current inflation. In any case, the
model’s absurd predictions make it a poor tool
for policy analysis. 
As Marvin discusses, researchers have tried
to fix the New Synthesis model by adding cost
shocks, combining rigidity in wages and prices,
and so on. In most cases, the output-inflation
trade-off still has the wrong sign. The only thing
that works is adding lagged inflation to the
Phillips curve. But the New Synthesis model does
not justify this term. Adding it is equivalent to
ignoring the model and going back to the accel-
erationist Phillips curve.
WHY HAS THE FED SUCCEEDED
(COMPARED WITH OTHER 
CENTRAL BANKS)?
As President Poole told us, this conference
celebrates the Fed’s success over the past 25 years.
I think the celebratory mood reflects a consensus
that the Fed has performed better than most cen-
tral banks. Like undergraduates, central banks
are graded on a curve. So let’s discuss how the
Fed has outperformed its peers. 
The Fed has not been unusually successful
in reducing inflation. All major countries have
done this. Table 1 shows inflation rates in 1979
and 2003 for 18 developed countries. In 1979,
inflation ranged from 4 percent in the Netherlands
to 24 percent in Portugal; the United States was
near the middle of the pack at 11.5 percent. In
2003, most inflation rates were near 2 to 3 percent;
the U.S. rate of 2.3 percent was again about aver-
age. Since 1979, central banks around the world
have been determined to reduce inflation. And
it’s easy to accomplish this goal if policymakers
are willing to slow the economy sufficiently. 
What does distinguish the Fed’s record is the
relatively benign behavior of U.S. unemployment.
Table 2 gives summary statistics for unemploy-
ment since the end of the Volcker disinflation
Ball
FEDERAL RESERVE BANK OF ST. LOUIS REVIEW MARCH/APRIL, PART 2 2005 265(1984-2003). The first column of the table ranks
countries by average unemployment. The U.S.
figure of 5.8 percent is in the lower part of the
distribution.
Of course it is doubtful whether central banks
influence average unemployment. They have
greater effects on volatility. The second column
of Table 2 ranks countries by the standard devia-
tion of annual unemployment, and here the United
States is tied for lowest.
The final column shows the highest annual
unemployment rate in each country. This statistic
measures central banks’ success in avoiding deep
recessions. For the United States, the highest
unemployment rate is 7.5 percent. This figure is
beaten only by Japan (where unemployment is a
misleading measure of slack) and Norway (by less
than 1 percent). The median of highest unemploy-
ment across countries is 10.5 percent. I think the
experience of deep recessions is why most central
banks are not celebrating the past 25 years. 
What Accounts for Moderate
Unemployment? 
Marvin suggests an explanation for the U.S.
unemployment experience. He attributes it to
the Fed’s determination to control inflation:
[A] central bank committed to making low
inflation a priority can anchor inflation
expectations and improve the stability of
both inflation and output relative to poten-
tial...[T]he unemployment cost (associ-
ated with go-stop policy and inflation
scares) of failing to make low and stable
inflation a priority is now well under-
stood. (Goodfriend, 2005, pp. 244, 252)
I think Marvin is off by 180 degrees. The Fed
has done better than other central banks because
it has not been as single-minded about fighting
inflation. It has reduced inflation, but it has also
paid attention to the real economy. In particular,
it has eased aggressively during recessions. This
behavior accounts for the Fed’s high rankings in
Table 2.
This point is clear from a 1994 paper by Romer
and Romer, “What Ends Recessions?” Romer and
Romer examine the Fed’s reaction to each U.S.
recession between World War II and the early
1990s. In every case, the Fed cut interest rates
sharply near the start of the recession. Volcker
and Greenspan were at least as aggressive as their
predecessors. Since Romer and Romer’s paper,
this pattern has continued with the recession of
2001.
Marvin notes the Fed’s reaction to the 1980
recession, but he is critical: “[T]he Fed’s hesita-
tion to tighten policy at the first sign of recession
probably contributed to the inflation scare” (pp.
248). In contrast, Romer and Romer show that Fed
easings were essential for ending recessions. And
these actions did not conflict with disinflation.
In particular, Volcker eased when recessions
started in 1980 and 1981, points when inflation
was still high. However, because of earlier tight-
ening, there was plenty of disinflation in the
monetary pipeline. 
I have compared the Fed’s responses to reces-
sions with those of other central banks (Ball, 1999).
In many countries, policymakers have not cut
Ball
266 MARCH/APRIL, PART 2 2005 FEDERAL RESERVE BANK OF ST. LOUIS REVIEW
Table 1
CPI Inflation (%)
Country 1979 2003 Change
Portugal 23.5 3.3 –20.2
Spain 15.7 3.0 –12.7
Italy 14.6 2.7 –11.9
New Zealand 13.7 1.8 –11.9
United Kingdom 13.5 2.9 –10.6
Ireland 13.2 3.5 –9.7
United States 11.3 2.3 –9.0
France 10.7 2.1 –8.6
Denmark 9.6 2.1 –7.5
Finland 7.5 0.9 –6.6
Canada 9.1 2.8 –6.3
Australia 9.1 2.8 –6.3
Sweden 7.2 1.9 –5.3
Japan 3.7 –0.3 –4.0
Germany 4.1 1.1 –3.0
Belgium 4.5 1.6 –2.9
Norway 4.8 2.5 –2.3
Netherlands 4.2 2.1 –2.1
 interest rates when recessions occurred. Conse-
quently, unemployment has stayed high or risen
further.
Let me discuss one example from the United
Kingdom. A U.K. recession began in 1979, but
the Bank of England kept interest rates high. The
Bank explained why in its Quarterly Bulletin of
June 1980:
Government fiscal and monetary policies
are designed to bring about a progressive
reduction in inflation, and need to be con-
tinued until that end is accomplished: a
less restrictive policy would clearly be
inappropriate at a time when inflation is
so high...The influence of monetary
restraint can only be gradual and perva-
sive, with effects to be looked for over a
period of years.
The Bank of England showed none of the Fed’s
“hesitation” about tightening during a recession.
Policy stayed tight until the mid-1980s.
The main effect of this tough policy was to
keep unemployment high. Unemployment stayed
above 10 percent through 1986. In the United
States, by contrast, unemployment was high in
1982-83 but then fell rapidly. Inflation fell by
about the same amount in the two countries, so
the United Kingdom’s extra unemployment did
not accomplish much. 
In the 1980s and 1990s, it was common for
European central banks to maintain tight policy
during recessions. Sometimes the reason was anti-
inflationary zeal, as in the United Kingdom. In
other cases, such as in France in the 1980s, policy-
makers wanted to ease but were constrained by the
exchange rate mechanism. Either way, excessive
tightness produced unnecessary unemployment.
CONCLUSION: THEORY AND
PRACTICE
Current monetary theory encourages central
banks to focus single-mindedly on fighting infla-
Ball
FEDERAL RESERVE BANK OF ST. LOUIS REVIEW MARCH/APRIL, PART 2 2005 267
Table 2
Unemployment 1984-2003
Country Mean Country Standard deviation Country Maximum
Japan 3.3 United States 1.1 Japan 5.4
Norway 4.3 France 1.1 Norway 6.6
Sweden 5.4 Japan 1.1 United States 7.5
Netherlands 5.6 Italy 1.3 Netherlands 8.9
United States 5.8 Belgium 1.4 Portugal 9.2
Portugal 6.1 Australia 1.4 Denmark 9.6
Denmark 6.3 Norway 1.5 Germany 9.7
New Zealand 6.6 Canada 1.5 Sweden 9.9
Germany 7.4 Germany 1.5 New Zealand 10.4
Australia 7.9 Denmark 1.5 Australia 10.6
United Kingdom 8.0 Portugal 1.7 Belgium 10.8
Belgium 8.5 New Zealand 1.9 United Kingdom 11.2
Canada 9.0 Netherlands 1.9 Canada 11.4
Finland 9.3 United Kingdom 2.1 France 11.7
Italy 9.8 Spain 2.9 Italy 11.7
France 9.9 Sweden 2.9 Finland 16.8
Ireland 11.7 Finland 4.3 Ireland 16.8
Spain 15.2 Ireland 4.8 Spain 19.8
 268 MARCH/APRIL, PART 2 2005 FEDERAL RESERVE BANK OF ST. LOUIS REVIEW
Ball
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American Economic Review, March 1968, 58, pp.
1-17.
Goodfriend, Marvin. “The Monetary Debate Since
October 1979: Lessons for Theory and Practice.”
Federal Reserve Bank of St. Louis Review,
March/April 2005, 87(2, Part 2), pp. 243-62.
Mankiw, N. Gregory. “The Inexorable and Mysterious
Trade-off Between Unemployment and Inflation.”
Economic Journal, May 2001, 111(471), pp. C45-61.
Nelson, Edward. “The Great Inflation of the Seventies:
What Really Happened?” Working Paper 2004-001,
Federal Reserve Bank of St. Louis.
Romer, Christina D. and Romer, David H. “What
Ends Recessions?” in Stanley Fischer and Julio J.
Rotemberg, eds., NBER Macroeconomics Annual
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Sargent, Thomas J. “Stopping Moderate Inflations:
The Methods of Poincare and Thatcher,” in Rudiger
Dornbusch and Mario Henrique Simonsen, eds.,
Inflation, Debt, and Indexation. Cambridge, MA:
MIT Press, 1983.
Zhang, Lawrence Huiyan. “Sacrifice Ratios with
Long-lived Effects.” Working Paper 446, Johns
Hopkins University, April 2001.
tion. In rational expectations models, this focus
benefits the real economy as well as reduces infla-
tion. Unfortunately, there is little evidence that
this approach works in the real world.
Many central banks have followed the pre-
scriptions of theory. They have kept policy tight,
even during recessions. This behavior has pro-
duced long periods of high unemployment.
The Fed’s approach to policy has been more
balanced. It has tried to control both inflation and
unemployment, and it has succeeded. Fortunately,
like Laurence Meyer, the Fed has not learned
modern theory too well.
REFERENCES
Ball, Laurence. “Aggregate Demand and Long-Run
Unemployment.” Brookings Papers on Economic
Activity, 1999, 2, pp. 189-251.
Ball, Laurence and Sheridan, Niamh. “Does Inflation
Targeting Matter?” in Ben S. Bernanke and Michael
Woodford, eds., The Inflation-Targeting Debate.
Chicago: University of Chicago Press, 2005.
Bank of England. Quarterly Bulletin, June 1980.
Debelle, Guy and Fischer, Stanley. “How Independent
Should a Central Bank Be?” in Jeffrey C. Fuhrer, ed.,
Goals, Guidelines, and Constraints Facing Monetary
Policymakers. Boston: Federal Reserve Bank of
Boston, 1994.

Aggregate Demand and Long-Run Unemployment.” Brookings Papers on Economic Activity,

How Independent Should a Central Bank Be?”

Commentary on "the monetary policy debate since October 1979: lessons for theory and practice"

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