Do search frictions matter for inflation dynamics?

We assess the empirical relevance for inflation dynamics of accounting for the presence of search frictions in the labor market. The new Keynesian Phillips curve explains inflation as being mainly driven by current and expected future marginal costs. Recent empirical research has emphasized different measures of real marginal costs to be consistent with observed inflation persistence. We argue that, allowing for search frictions in the labor market, real marginal cost should also incorporate the cost of generating and maintaining long-term employment relationships, along with conventional measures, such as real unit labor costs. In order to construct a synthetic measure of real marginal costs, we use newly available labor market data on worker finding and separation rates that reflect hiring and firing costs. We then estimate a new Keynesian Phillips curve by generalized method of moments (GMM) using the imputed marginal cost series as an observable and find that the contribution of labor market frictions in explaining inflation dynamics is small.     

Does immigration affect the Phillips curve? Some evidence for Spain

The Phillips curve has flattened in Spain over 1995-2006: Unemployment has fallen by 15 percentage points, with roughly constant inflation. This change has been much more pronounced than elsewhere. We argue that this stems from the immigration boom in Spain over this period. We show that the New Keynesian Phillips curve is shifted by immigration if natives’ and immigrants’ labor supply elasticities and bargaining power differ. Estimation of this curve for Spain indicates that the fall in unemployment since 1995 would have led to an annual increase in inflation of 2.5 percentage points if it had not been largely offset by immigration.     

Inventories,inflation dynamics and the New Keynesian Phillips curve

We introduce inventories into an otherwise standard New Keynesian model and study the implications for inflation dynamics. Inventory holdings are motivated as a means to generate sales for demand-constrained firms. We derive various representations of the New Keynesian Phillips curve with inventories and show that one of these specifications is observationally equivalent to the standard model with respect to the behavior of inflation when the model's cross-equation restrictions are imposed. However, the driving variable in the New Keynesian Phillips curve – real marginal cost – is unobservable and has to be proxied by, for instance, real unit labor cost. An alternative approach is to impute marginal cost by using the model's optimality conditions. We show that the stock–sales ratio is linked to marginal cost. We also estimate these various specifications of the New Keynesian Phillips curve using GMM. We find that the predictive power of the inventory-specification at best approaches that of the standard model, but does not improve upon it.     

Output gap measurement and the New Keynesian Phillips curve for China

The New Keynesian Phillips curve implies that the output gap, the deviation of the actual output from its natural level due to nominal rigidities, drives the dynamics of inflation relative to expected inflation and lagged inflation. This paper exploits the empirical success of the New Keynesian Phillips curve in explaining China's inflation dynamics with a new measure of the output gap. We estimate the output gap using the Bayesian multivariate Beveridge–Nelson decomposition method, based on a multivariate dynamic model featuring distinct interactions among inflation, money, and real output in China. The empirical results using quarterly data spanning 1979–2010 show that the new measure of the output gap outperforms the traditional measures in fitting the New Keynesian Phillips curve. This result provides useful insights for inflation dynamics and monetary policy analysis in China.     

The economics of the Phillips curve: Formation of inflation expectations versus incorporation of inflation expectations

This paper examines the theory of the Phillips curve, focusing on the distinction between “formation” of inflation expectations and “incorporation” of inflation expectations. Phillips curve theory has largely focused on the former. Explaining the Phillips curve by reference to expectation formation keeps Phillips curve theory in the policy orbit of natural rate thinking where there is no welfare justification for higher inflation even if there is a permanent inflation–unemployment trade-off. Explaining the Phillips curve by reference to incorporation of inflation expectations breaks that orbit and provides a welfare economics rationale for Keynesian activist policies that reduce unemployment at the cost of higher inflation.     

Does a factor Phillips curve help? An evaluation of the predictive power for U.S. inflation

This article evaluates various models’ predictive power for U.S. inflation rate using a simulated out-of-sample forecasting framework. The starting point is the traditional unemployment Phillips curve. We show that a factor Phillips curve model is superior to the traditional Phillips curve, and its performance is comparable to other factor models. We find that a factor AR model is superior to the factor Phillips curve model, and is the best bivariate or factor model at longer horizons. Finally, we investigate a New Keynesian Phillips curve model, and find that its forecasting performance dominates all other models at the longer horizons.     

The empirical validity of the New Keynesian Phillips curve using survey forecasts of inflation

This paper investigates the performance of the New Keynesian Phillips curve when survey forecasts of inflation are used to proxy for inflation expectations. Previous authors such as Brissimis and Magginas (2008) have applied survey measures of inflation expectations to the NKPC, and have concluded that these estimates are superior to those estimated using actual data on future inflation. However this approach employs the use of the labor income share as the proxy for real marginal cost, something which is highly problematic once we consider the countercyclicality of this variable. This paper develops and tests a procyclical marginal cost variable alongside various survey measures of inflation forecasts in the NKPC, while recognizing the problem of weak instruments that occurs when estimating the model using conventional GMM. We find that the NKPC produces a counter-intuitive negative and significant coefficient on procyclical marginal cost when surveys of inflation forecasts are used, which casts serious doubt on the empirical viability of the NKPC model, even when estimated with survey inflation forecasts.     

Inflation dynamics and the cost channel of monetary transmission

Evidence from vector autoregressions indicates that the impact of interest rate shocks on macroeconomic aggregates can substantially be affected by the so-called cost channel of monetary transmission. In this paper, we apply a structural approach to examine the relevance of the cost channel for inflation dynamics in G7 countries. Since firms’ costs of working capital increase with interest rates, we augment a (hybrid) New Keynesian Phillips curve by including the short-run nominal interest rate. We find significant and varying direct interest rate effects for the majority of countries, including member countries of the EMU. Simulations further demonstrate that the estimated interest rate coefficients can substantially affect inflation responses to monetary policy shocks, and can even lead to inverse inflation responses, when the cost channel is - relative to the demand channel - sufficiently strong.     

The New Keynesian Phillips curve and the role of expectations: Evidence from the CESifo World Economic Survey

We provide evidence on the fit of the hybrid New Keynesian Phillips curve for selected Euro zone countries, the US and the UK. Instead of imposing rational expectations and estimating the Phillips curve by the Generalized Method of Moments, we use direct measures of inflation expectations from the CESifo World Economic Survey. Our main findings are as follows: (i) The use of survey data gives empirical results, which are more reliable than those obtained from the GMM approach. (ii) The purely forward-looking Phillips curve can be rejected in favor of the hybrid New Keynesian Phillips curve. (iii) The estimated coefficients on past inflation are higher when using survey expectations than when using the rational expectations GMM approach. (iv) It remains unclear whether real unit labor costs or a measure of the output gap should be used as a proxy for real marginal costs. (v) Theory-based restrictions lead to an improvement of the empirical results.     

Inflation and Unemployment in General Equilibrium*

When labor is indivisible, there exist efficient outcomes with some agents randomly unemployed, as in Rogerson (1988) . We integrate this idea into the modern theory of monetary exchange, where some trade occurs in centralized markets and some in decentralized markets, as in Lagos and Wright (2005) . This delivers a general equilibrium model of unemployment and money, with explicit microeconomic foundations. We show that the implied relation between inflation and unemployment can be positive or negative, depending on simple preference conditions. Our Phillips curve provides a long‐run, exploitable, trade‐off for monetary policy; it turns out, however, that the optimal policy is the Friedman rule.     

Cost-based Phillips Curve forecasts of inflation

It is a well-established idea that prices are a function of marginal cost, yet estimating a reliable measure of marginal cost is difficult to do. Stock and Watson (1999) use the Phillips Curve to forecast inflation for a variety of existing activity variables that researchers commonly use to proxy for marginal cost. This paper uses a similar type of approach to examine the performance of a new candidate for the activity variable, which is marginal cost measured following the theoretical methodology of Bils (1987), which we find to be simple yet powerful when implemented empirically. We then use the Phillips Curve to conduct pseudo out-of-sample inflation forecasts for the US using: output, unemployment, hours, the labor share, the capacity utilization rate, and the new measure of marginal cost. For almost all cases, forecast errors are lowest in the regressions with the new marginal cost variable, indicating that this new measure is an improvement over previous attempts to proxy for marginal cost.     

Comparing alternative Phillips curve specifications: European results with survey-based expectations

This article examines inflation dynamics in Europe. Econometric specification tests with pooled European data are used to compare the empirical performance of the New Classical, New Keynesian and Hybrid specifications of the Phillips curve. Instead of imposing any specific form of expectations formation, direct measures, i.e. Consensus Economics survey data are used to proxy economic agents’ inflation expectations. According to the results, the New Classical Phillips curve has satisfactory statistical properties. Moreover, the purely forward-looking New Keynesian Phillips curve is clearly outperformed by the New Classical and Hybrid Phillips curves. We interpret our results as indicating that the European inflation process is not purely forward looking and inflation cannot instantaneously adjust to changes in expectations. Consequently, even allowing for possible nonrationality in expectations results in a lagged inflation term entering the New Keynesian Phillips curve for inflation dynamics in Europe.     

The optimal neglect of inflation: An alternative interpretation of UK monetary policy during the “Great Moderation”

This paper argues that UK monetary policymakers did not respond to the inflation rate during most of the “Great Moderation” that ran from the early 1990s to the mid-2000s. We derive a generalisation of the New Keynesian Phillips curve in which inflation is a non-linear function of the output gap and show that the optimal response of the policy rule to inflation depends on the slope of the Phillips curve; if this is flat, manipulation of aggregate demand through monetary policy does not affect inflation and so policymakers cannot affect inflation. We estimate the monetary policy rules implied by a variety of alternative Phillips curves; our preferred model is based on a Phillips curve that is flat when output is close to equilibrium. We find that policy rates do not respond to inflation when the output gap is small, a situation that characterised most of the “Great Moderation” period.     

New Keynesian Phillips Curve and inflation dynamics in Australia

The New Keynesian Phillips Curve (NKPC) was developed as a response to the New Classical critique that Keynesian macroeconomics lacked micro-foundations. The NKPC provides theoretical micro-foundations that attempt to explain, inter alia, nominal rigidities and, explicitly price stickiness. This paper investigates the validity of the NKPC for Australia. In contrast to the findings for the USA and Euro area, we find that neither the output gap nor marginal cost appears to be a key driving force variable across different set of instruments and estimators (GMM and 2SLS) over the sample period from 1959 to 2009. The flattening of the NKPC along with significant presence of price stickiness is also found in the data. In particular, the reduced form coefficients and implied estimates from the structural parameters of the model support the view that inflation dynamics are forward looking while the role of lagged inflation is also statistically important only after 1980s. However, we claim that the forward looking baseline NKPC contrary to the hybrid NKPC is stable and better explains inflation dynamics for the Australian economy.     

Macroeconomic Stability or Cycles? The Role of the Wage‐Price Spiral

We formulate a small and stylised dynamic macroeconomic model, and study how different specifications of the supply side affect the model's dynamic properties. The wage‐price equilibrium‐correction model (ECM) and the Phillips curve model (PCM) that both can be used to represent the supply side of a New Keynesian macro model, are synthesised in a generalised model of the wage‐price spiral. We show that the choice of ECM or PCM has implications for the long‐run stability of the macro model, without need of a NAIRU. We also find that the range of theoretically admissible dynamics is wide. For example, both the ECM and PCM may display endogenous cyclical fluctuations in inflation and unemployment, showing that even simple structures can give rise to complex dynamics. In practice that may entail that forecasting the effects of shocks and policy changes is difficult even in the best of circumstances.     

INFLATION IN CHINA: MODELLING A ROLLER COASTER RIDE

Abstract.  The New Keynesian Phillips curve (NKPC) posits the dynamics of inflation as forward looking and related to marginal costs. In this paper we examine the empirical relevance of the NKPC for China. The empirical results indicate that an augmented (hybrid) NKPC gives results that are consistent with the data generating process. It is in this respect that the NKPC provides useful insights into the nature of inflation dynamics in China as well as useful insights for the conduct of monetary policy.     

The New Keynesian Phillips curve in Europe: does it fit or does it fail?

The canonical New Keynesian Phillips curve specifies inflation as the present-value of future real marginal costs. This paper exploits projections of future real marginal costs generated by VAR models to assess the model’s ability to match the behavior of actual inflation in the Euro area. The model fits the data well at first sight. A set of bias-corrected bootstrapped confidence bands, however, reveals that this result is consistent with both a well fitting and a failing model. These findings also hold for the hybrid version of the Phillips curve.     

Nonlinearities in the U.S. wage Phillips curve

We examine the relationship between wage inflation and the unemployment rate in the U.S. economy for the 1964–2014 period by means of a three-regime threshold regression model. The estimated threshold parameters suggest that this relationship changes when the unemployment rate transitions between regimes defined by 5.61% and 7.63%. During mild recessions and their subsequent recoveries, the time-varying estimates of the model indicate a negative relationship between both variables, consistent with the implications of a wage Phillips curve (WPC) derived from the standard New Keynesian model with staggered wage setting in Galí (2011). However, we find that this relationship breaks down during deep recessions and their recovery periods, which explains the difference between wage inflation predicted by standard New Keynesian models and the observed low wage growth in the aftermath of the ‘Great Recession’. This finding and the fact that statistical tests strongly favor our three-regime model suggest that linear and two-regime models are insufficient to account for all the variability in the relationship between wage inflation and unemployment.     

Inflation Dynamics in the Euro Area and the Role of Expectations

This paper examines the empirical performance of the New Keynesian Phillips curve and its hybrid specification in the euro area. Instead of imposing rational expectations, direct measures, i.e. OECD forecasts, are used as empirical proxies for economic agents’ inflation expectations. Real marginal costs are proxied by three alternative measures. The results suggest that once the rational expectations hypothesis is relaxed and directly measured expectations are used, the European inflation process can be modeled using the forward-looking New Keynesian Phillips curve. However, when allowing for possible non-rationalities in expectations, inflation can be modeled more accurately by the hybrid Phillips curve with the additional lagged inflation term. In this approach, output gap turns out to be at least as good as labor income share as a proxy for real marginal cost. Moreover, the inflation process seems to have become more forward-looking in the recent years of low and stable inflation.The views expressed are those of the author and do not necessarily reflect the views of the Bank of Finland. Special thanks are due to the editor, two anonymous referees, Juha Tarkka, Jouko Vilmunen and Matti Virén for useful comments. I am also grateful to David Mayes and Geoffrey Wood for helpful suggestions and to Heli Tikkunen for excellent research assistance. For their constructive comments, I would also thank participants in the conference on the Eurosystem Inflation Persistence Network at the ECB, which was held in Frankfurt in December 2003.     

Domestic and global output gaps as inflation drivers: What does the Phillips curve tell?

We study how domestic and global output gaps affect CPI inflation. We use a New-Keynesian Phillips curve framework which controls for non-linear exchange rate movements for a panel of 26 advanced and 22 emerging economies covering the 1994Q1−2017Q4 period. We find that both global and domestic output gaps are significant drivers of inflation both in the pre-crisis (1994–2008) and post-crisis (2008–2017) periods. Furthermore, after the crisis, in advanced economies the effect of the domestic output gap declines, while in emerging economies the effect of the global output gap declines. Our results suggest that emerging and advanced economies have become more similar to each other in terms of output gaps as inflation drivers. The paper demonstrates the usefulness of the New Keynesian Phillips curve in identifying the impact of global and domestic output gaps on inflation.