Editors' Summary

The brookings panel on Economic Activity held its sixty-ninth conference in Washington, D.C., on March 30 and 31, 2000. This issue of Brookings Papers includes the papers and discussions presented at the conference. The first paper presents and tests a new model of inflation that rejects the conventional theory of a natural rate of unemployment. It shows that a rate of inflation that is above zero but too low to factor into the decisionmaking of most workers and employers will permit unemployment to be sustained well below its so-called natural rate. The second paper examines "new economy" explanations for the recent spectacular rise in stock prices by comparing the ability of stock values and professional forecasts of U.S. firms' earnings to predict firms' investment behavior. The third paper applies growth accounting methods to recently revised official U.S. productivity data to analyze the sources of the recent surge in productivity and to offer informed judgments about whether it is likely to continue. The fourth paper investigates the possibility of a link between share prices, interpreted as an indicator of future profitability, and unemployment across a sample of industrial countries whose unemployment rates diverged during the 1990s.

Since the 1970S many economists have accepted the idea of a natural rate of unemployment that describes a unique equilibrium for the real economy. The NAIRU, the empirical counterpart of the natural rate, has become part of the toolkit of policymakers and analysts, especially in the United States. And until the past few years, estimates of a relatively constant natural rate of about 6 percent have fit the actual behavior of the U.S. economy over the previous three decades reasonably well. Since then, however, the persistence of low inflation alongside unemployment rates that have fallen well below 6 percent has led most analysts to conclude that the U.S. NAIRU has fallen. In the first paper of this volume, George Akerlof, William Dickens, and George Perry go further and reject the natural rate model itself.

Over the years there has been considerable controversy about how to model the formation of expectations in empirical work with the natural rate model. Akerlof, Dickens, and Perry, by contrast, see how people use expectations, rather than how they form them, as the key. Rather than accept the standard economic assumption that people make the best use of all available information, the authors turn to a variety of sources for evidence about how people actually use information in making decisions. Supported by this evidence, they develop an alternative to the natural rate model that is based on behavioral assumptions they find more realistic and that fit the facts better. A striking feature of their model is that it exhibits, rather than a unique natural rate, a range of sustainable unemployment rates consistent with steady, low rates of inflation. The authors show that the lowest unemployment rate in this range is well below the natural rate as usually estimated.

The authors cite psychological studies that have found that decision-makers"edit" the information available to them, ignoring much that is potentially relevant in order to concentrate on the few factors that matter most. Similarly, studies on the psychology of perception show that an event or stimulus must pass a threshold before it is even perceived, let alone acted upon. In addition, from interviews with compensation professionals, the authors infer that wage setters do not behave as most economic models assume. Rather than choosing a real wage target and then adjusting it fully for expected inflation, they mix information about inflation with a variety of other information relevant to wage setting. And from interviews of the lay public by Robert Shiller and questionnaire studies by Eldar Shafir, Peter Diamond, and Amos Tversky, they find telling evidence about how people perceive and react to inflation. Employees systematically underestimate the tendency of inflation to boost their own nominal wages. Therefore, the authors reason, in periods of moderate inflation, employees' job satisfaction is likely to be high even if their real wage is unchanged. Employees are pleased by their wage increase and do not fully recognize the...