Rational expectations, supply shocks and the stability of the inflation-output tradeoff

Abstract

The Lucas (1973) supply curve is modified to incorporate both specific and aggregate supply shocks in addition to demand shocks. A time series test of the Rational Expectation Natural Rate (RENR) hypothesis is derived. Monthly data for the United Kingdom 1957–1977 are split into periods based on a moving variance procedure. Utilizing Zellner-Palm transfer functions it is shown that a significant reduction in the short-run inflation-output tradeoff is associated with an increase in the variance of the unanticipated price level. This provides evidence in favor of the RENR hypothesis. Moreover, the worsened tradeoff is shown to have been caused by higher supply side rather than demand side volatility.