Author: Hian Teck Hoon, Singapore Management University Book Review of Money and the Natural Rate of Unemployment by Finn Ostrup, Cambridge University Press, 2000 Published in The Journal of Economic Literature, June 2004, Vol. 42, No. 2, pp. 516-517. SPURRED by the need to understand the reasons behind the steady rise of unemployment in many of the OECD countries in the absence of sharp disinflations, economists have developed a class of models with an endogenous natural rate of unemployment. Within this framework, the natural rate is not perceived as a given constant that is invariant to shifts in economic and policy variables. Rather its level is determined as a solution to a generalequilibrium system. It is found, for instance, that actual and perceived rates of productivity growth matter for the determination of the natural rate; fiscal shocks affect the natural rate; and the tax and entitlement system also matters. In open economies, the external real interest rate and the terms of trade are important determinants of the natural rate of unemployment. However, monetary policy leaves the natural rate invariant. This property of monetary neutrality is preserved in this class of models with an endogenous natural rate of unemployment. This book by Professor Finn Ostrup makes a departure from this tradition, arguing that there are conditions under which the natural rate of unemployment can be affected by monetary variables despite imposing the conditions of nominal wage and price flexibility as well as rational expectations in modeling. The papers written by Professors Milton Friedman and Edmund Phelps in the 1960s argued that a negative relationship exists only between the excess of actual over expected inflation and the deviation of the actual from the natural rate of unemployment. In the long run, when the actual and expected inflation rates are equal, the Phillips curve was shown to be vertical at the exogenously given natural rate of unemployment. Research since the late 1980s challenged the notion that the natural rate is exogenous, and identified factors that shifted the vertical long-run Phillips curve. The book under review goes one step further to argue that the long-run Phillips curve may not be vertical after all, that is, the natural rate itself may not be invariant to the long-run rate of inflation. Whether one accepts Professor Ostrup’s view or not is important, for that view carries important policy implications. For example, if a higher long-run rate of inflation is associated with a lower natural rate of unemployment, the welfare rankings, based on the 1

Kydland-Prescott-Barro-Gordon time inconsistency framework that lead to a preference for rules-based monetary regimes over discretionary ones may no longer be valid. Part 1 of the book presents an overview of the class of models that lead to an endogenous natural rate of unemployment while preserving monetary neutrality. Part 2, which is the key part of the book, presents several models where monetary neutrality breaks down. Parts 3 and 4 examine the policy implications of the finding that money affects the natural rate. What mechanisms can plausibly explain how monetary variables can affect the natural rate of unemployment? The key is to identify conditions under which changes in money supply affect the domestic real interest rate and/or the terms of trade. Combine this with a story of an endogenous natural rate, where we recall that real interest rates and the terms of trade are important determinants of the equilibrium volume of joblessness, and it is plain to see that money affects the natural rate of unemployment. Students of international finance will be familiar with the first example worked out by Professor Ostrup. Consider a small open economy facing an exogenously given external real rate of interest. Assets denominated in the domestic currency are imperfect substitutes for foreign-currency-denominated assets. Consequently, the international interest arbitrage condition involves a risk premium. Suppose that the monetary authorities in our small open economy engage in an open market purchase of government securities. By lowering the risk premium, the domestic real interest rate is driven down, stimulating investment demand, and ultimately increasing the stock of physical capital. The result is to lift up the downwardsloping demand wage schedule, which juxtaposed against an upward-sloping wage curve in the Marshallian employment-wage plane, implies a decline in the natural rate of unemployment. Another way that monetary policy can have real effects on the equilibrium volume of joblessness despite doing away with nominal wage and price rigidity is to bring in the “credit channel.” Suppose that commercial bank loans and bonds are imperfect substitutes in the portfolios of banks. Then changes in central bank reserves work through the economy not only via the usual shifts of the LM curve, but also, through influencing the amount of bank lending, by affecting investment demand and ultimately the natural rate of unemployment.

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With a high jobless rate still plaguing many industrial economies today, this book is a welcome contribution to the research probing the forces shaping the natural rate of unemployment. A book that challenges the widely-held view that the long-run Phillips curve is vertical should be carefully studied by both academic researchers as well as policy-makers. We would like to know if there are compelling reasons to believe that the long-run Phillips curve is positively or negatively sloped within the range of inflation rates that lie, say, below ten percent. Will raising the long-run inflation rate from, say, two to four percent lead to a lower natural rate of unemployment? Unfortunately, the special assumptions used in this book to provide a range of different models giving rise to monetary non-neutrality does not allow an unambiguous answer to the question. More research needs to be done to pin down the answer.

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