Foundations of the Goldilocks Economy: Supply Shocks and the Time-Varying NAIRU

THE AMERICAN ECONOMY of the mid-1990s has been a source of envy for the world and of puzzlement for macroeconomists.The civilian unemployment rate has remained below 5 percent for one year and below 6 percent for almost four years.Despite near universal forecasts in 1994 of accelerating inflation that would accompany a dip of the unemployment rate below 6 percent, inflation actually decelerated significantly between 1994 and 1998.This benign outcome for inflation stands in contrast to the significant acceleration that occurred when unemployment last dipped below 6 percent, in the late 1980s.I The failure of inflation to accelerate allowed the Federal Reserve to avoid raising short-term interest rates after early 1997, and even to lower them in late 1998.Freed from the restraint of restrictive monetary policy that had choked earlier expansions, and with its fires stoked by the lowest medium-term and long-term nominal interest rates in three decades, the economy charged ahead and achieved a state of high This research is supported by the National Science Foundation.I am grateful to William Nordhaus and to participants of the Brookings Panel meeting for helpful comments.Christian Ehemann and Steven Landefeld were invaluable, both in providing data and helping me to understand them.Aarti Dhupelia, Tominori Ishikawa, and Stuart Gurrea provided excellent research assistance.Above all, I am greatly indebted to James Stock for his role in developing the methodology adopted in this paper, and for his instant and insightful responses to my endless queries about how to merge his new techniques with my traditional specification of the Phillips curve.1.The four-quarter rate of change of the chain-weighted GDP deflator decelerated from 2.5 percent in 1994:3 to 1.0 percent