Unfinished Business in the Macroeconomics of Low Inflation: A Tribute to George and Bill by Bill and George

The retirement of George Perry and William Brainard as editors of the Brookings Papers gives us an opportunity to say publicly what we have often said privately: the Brookings Papers is an important national institution. It is important because it has set the right tone for U.S. macroeconomic policy. George and Bill are both Keynesians, not just in the narrow tradition of IS-LM models with Phillips curves, but also in their broader methodological approach to macroeconomics. The Brookings Papers has always reflected their view that macroeconomics should be a pragmatic and judicious mixture of theory and common sense, informed by statistical analysis. That of course reflects the methodology of Keynes, throughout his life and especially in The General Theory. We think that U.S. macroeconomic policy has benefited enormously from such a balanced pragmatic-empirical approach.

Anyone who doubts the benefits of such an approach to macroeconomics needs only look to the north—to Canada—where doctrinaire use of an extreme form of natural rate theory in the 1990s led policymakers to push inflation too low, resulting in an unusually wide unemployment gap relative to the United States. This is just one example where a more empirical, more nuanced macroeconomics—such as presented for the last thirty years in the Brookings Papers—has implications for national welfare. Macroeconomic policy, as no one appreciated better than Keynes, often even makes the difference between prosperity and depression.

It will be a hard task for the new editors to take the place of George and Bill, and we wish them luck. Neither this Bill nor this George has ever envied George and Bill their difficult job. They have edited the Brookings Papers the hard way. The easy way is to trawl the conferences and the economics department hallways for the best of what already exists. Instead, for the most part, George and Bill recruited people to push forward their pragmatic agenda for macroeconomic research. The influence of George and Bill, even in the late stages of producing these papers, is clear to all members of the Brookings Panel. We have continued to be amazed at how George and Bill could take the meeting drafts, which were not always in the best of shape, and quickly turn them into interesting, readable gems. In short, they have done the impossible: admittedly with some very good help from their authors, they have produced something like eight to twelve significant and relevant new papers on macroeconomics per year, year after year.

Some Background on This Paper

This volume in honor of George Perry and William Brainard is an opportunity to reflect back on the two Brookings Papers we wrote with Perry (with comments and occasional help from Brainard) on the macroeconomics of low inflation.¹ Although they took somewhat different approaches, these two papers had similar policy implications. Both found a significant cost of permanently low inflation in terms of permanently high unemployment.

Each paper examined the effects of a different type of money illusion. The earlier paper, "The Macroeconomics of Low Inflation," examined the consequences of downward nominal wage rigidity, or resistance to nominal wage cuts. "Near-Rational Wage and Price Setting" examined the consequences of people thinking in nominal rather than in real terms when inflation is very low. When this happens, a trade-off will emerge between inflation and unemployment—not just in the short run, but also in the long run when actual inflation and expected inflation are equal.

Although the existence of such a trade-off was previously well known, its magnitude was not. Both papers found surprisingly large long-run increases in unemployment from permanent reductions in inflation to zero. For example, in the benchmark simulation in the first paper, with limited nominal wage cuts for continuing workers, we found that a permanent reduction in annual inflation from 2 percent to zero would increase unemployment by 1.5 percentage points; when we estimated a benchmark Phillips curve using time-series data, unemployment increased permanently by 2.6 percentage...