An open-economy new Keynesian Phillips curve for the U.K.

We estimate a pricing equation or “new Keynesian Phillips curve” (NKPC) obtained from a structural dynamic model of price setting based on Rotemberg [1982. Sticky prices in the United States. Journal of Political Economy 90(6), 1187-1211] and extended to capture employment adjustment costs and the openness of the United Kingdom. This model nests the baseline Galí and Gertler [1999. Inflation dynamics: a structural econometric analysis. Quarterly Journal of Economics 110, 127-159) and Sbordone [2002. Prices and unit labor costs: a new test of price stickiness. Journal of Monetary Economics 49, 265-292] relationship between inflation and marginal cost in the limiting case of no employment adjustment costs, no impact of relative prices of imported inputs on real marginal cost and a constant equilibrium markup. Our findings indicate that each of our modifications to the baseline NKPC model is important for U.K. data, so that inflation in the U.K. is explained both by changes in employment and by changes in real import prices, in general, and real oil prices, in particular. External competitive pressures also seem to affect U.K. inflation via their impact on the equilibrium price markup of domestic firms.     

The New Keynesian Phillips Curve: From Sticky Inflation to Sticky Prices

The New Keynesian Phillips Curve (NKPC) model of inflation dynamics based on forward-looking expectations is of great theoretical significance in monetary policy analysis. Empirical studies, however, often find that backward-looking inflation inertia dominates the dynamics of the short-run aggregate supply curve. This inconsistency is examined by investigating multiple structural changes in the NKPC for the U.S. between 1960 and 2005, employing both inflation expectations survey data and a rational expectations approximation. We find that forward-looking behavior plays a smaller role during the high and volatile inflation regime to 1981 than in the subsequent period of moderate inflation, providing empirical support for sticky price models over the last two decades. A break in the intercept of the NKPC is also identified around 2001 and this may be associated with U.S. monetary policy in that period.     

Trend Inflation and the Nature of Structural Breaks in the New Keynesian Phillips Curve

We show that with a unit root in inflation, the new Keynesian Phillips curve (NKPC) implies an unobserved components model with a stochastic trend component and an inflation gap. Our empirical results suggest that with an increase in trend inflation during the Great Inflation, the response of inflation to real economic activity decreases and the persistence of the inflation gap increases due to an increase in the persistence of the unobserved stationary component. These results are in line with the predictions of Cogley and Sbordone ( 2008 ), who show that the coefficients of the NKPC are functions of time‐varying trend inflation.     

Implications of state-dependent pricing for dynamic macroeconomic models

State-dependent pricing (SDP) models treat the timing of price changes as a profit-maximizing choice, symmetrically with other decisions of firms. Using quantitative general equilibrium models which incorporate a “generalized (S,s) approach,” we investigate the implications of SDP for topics in two major areas of macroeconomic research, the early 1990s SDP literature and more recent work on persistence mechanisms. First, we show that state-dependent pricing leads to unusual macroeconomic dynamics, which occur because of the timing of price adjustments chosen by firms as in the earlier literature. In particular, we display an example in which output responses peak at about a year, while inflation responses peak at about 2 years after the shock. Second, we examine whether the persistence-enhancing effects of two New Keynesian model features, namely specific factor markets and variable elasticity demand curves, depend importantly on whether pricing is state dependent. In an SDP setting, we provide examples in which specific factor markets perversely work to lower persistence, while variable elasticity demand raises it.     

Phillips Correlation and Price-Change Distributions under Declining Trend Inflation

The relationship between inflation dynamics and micro-level pricing behavior is an underexplored research area. In this article, we first document that deflationary periods in Japan were associated with (i) variations in the distribution of price changes at the micro level, and (ii) a weakening in the Phillips correlation at the macro level. We construct a multisector general equilibrium model with sector-specific menu costs, a feature that is supported by our estimation using sectoral data, and show that declining trend inflation and an increasing share of services in private consumption together can quantitatively explain the above two observations.     

New tests of the new-Keynesian Phillips curve

Lagged dependent variables typically play an important role in empirical models of inflation. Do these lags reflect backward-looking inflation expectations, or do they proxy for rational forward-looking expectations, as in the new-Keynesian Phillips curve? Galí and Gertler [1999. Inflation dynamics: a structural econometric analysis. Journal of Monetary Economics 44, 195-222] attempt to answer this question using GMM to estimate specifications incorporating both lagged and future inflation. They report small coefficients on lagged inflation and conclude that the new-Keynesian model provides a good first approximation to inflation dynamics. We show that these tests have low power against alternative backward-looking specifications, and demonstrate that their results are also consistent with a backward-looking Phillips curve. Using an alternative approach, we find that the new-Keynesian pricing model cannot explain the importance of lagged inflation in standard inflation regressions, and find that forward-looking terms play a very limited role in explaining inflation dynamics.     

International Evidence on the New Keynesian Phillips Curve Using Aggregate and Disaggregate Data

We present a unique empirical analysis of the properties of the New Keynesian Phillips Curve (NKPC) using an international data set of aggregate and disaggregate sectoral inflation. Our results from panel time‐series estimation clearly indicate that sectoral heterogeneity has important consequences for aggregate inflation behavior. Heterogeneity helps to explain the overestimation of inflation persistence and underestimation of the role of marginal costs in empirical investigations of the NKPC that use aggregate data. We find that combining disaggregate information with heterogeneous‐consistent estimation techniques helps to reconcile, to a large extent, the NKPC with the data.     

Endogenous Price Stickiness,Trend Inflation,and Macroeconomic Stability

Previous studies show that higher trend inflation is more likely to induce indeterminacy of equilibrium in sticky‐price models based on micro evidence that each period a fraction of prices is kept unchanged. This paper demonstrates that when the degree of price stickiness is endogenously determined in a Calvo model, indeterminacy caused by higher trend inflation is less likely. A key factor for determinacy is the long‐run inflation elasticity of output implied by the New Keynesian Phillips curve. This elasticity declines substantially with higher trend inflation in the case of exogenously given price stickiness, whereas in the case of endogenous price stickiness the decline in the elasticity is mitigated because higher trend inflation leads to a higher probability of price adjustment.     

Inventory Investment and the Empirical Phillips Curve

In this paper, we study the Calvo pricing models with finished goods inventory investment to demonstrate that the current inflation can be expressed as a function of the marginal cost of sales, not the marginal production cost, and expected future inflation. Under the assumption that the true aggregate marginal costs are not observable in actual data, we make use of equilibrium conditions for aggregate finished goods inventories to measure the time series of marginal costs, thereby leading to the construction of inflation series on the basis of the Phillips curve. Our results indicate the possibility of a successful fit of the empirical New Keynesian Phillips curve without relying on unit labor cost—a conventional measure of marginal production cost in the literature.     

What Makes the Output–Inflation Trade‐Off Change? The Absence of Accelerating Deflation in Japan

It is standard to model the output–inflation trade-off as a linear relationship with a time-invariant slope. We assess empirical evidence for two sets of theories that allow for endogenous variation in the slope of the short-run Phillips curve. At an empirical level, we examine why large negative output gaps in Japan in the late 1990s did not lead to accelerating deflation but instead coincided with stable, albeit moderately negative inflation. Our results suggest that this episode is most convincingly interpreted as reflecting a gradual flattening of the Phillips curve. We find that this flattening is best explained by models with endogenous price durations. These models imply that in any economy where trend inflation is substantially lower (or substantially higher) today than in past decades, time variation in the slope of the Phillips curve has become too important to ignore.     

A Phillips Curve with Anchored Expectations and Short‐Term Unemployment

This paper examines the behavior of U.S. core inflation, as measured by the weighted median of industry price changes. We find that core inflation since 1985 is well‐explained by an expectations‐augmented Phillips curve in which expected inflation is measured with professional forecasts and labor‐market slack is captured by the short‐term unemployment rate. We also find that expected inflation was backward‐looking until the late 1990s, but then became strongly anchored at the Federal Reserve's target. This shift in expectations changed the relationship between inflation and unemployment from an accelerationist Phillips curve to a level‐level Phillips curve. Our specification explains why high unemployment during the Great Recession did not reduce inflation greatly: partly because inflation expectations were anchored, and partly because short‐term unemployment rose less sharply than total unemployment.     

Inflation and output dynamics with state-dependent pricing decisions

This paper studies a state-dependent pricing model in which firms face a fixed cost of changing their pricing plans. A pricing plan specifies an entire sequence of time-varying future prices. Allowing firms to choose a pricing plan rather than a single price generates inflation inertia in the response of the economy to small changes in the growth rate of money. Allowing firms to choose when to change their pricing plan generates a non-linear response of inflation and output to small and large changes in the money growth rate. The non-linear solution method also reveals that the model generates an asymmetric response of output and inflation to monetary expansions and contractions.     

Estimating New-Keynesian Phillips curves: A full information maximum likelihood approach

The New-Keynesian Phillips curve has recently become an important ingredient in monetary policy models. However, using limited information methods, the empirical support for the New-Keynesian Phillips curve appear to be mixed. This paper argues, by means of Monte Carlo simulations with a simple New-Keynesian sticky price model, that single equations methods, e.g. GMM, are likely to produce imprecise and biased estimates. Then, it is argued that estimating the model with full information maximum likelihood (FIML) is a useful way of obtaining better estimates. Finally, a version of the model used in the Monte Carlo simulations is estimated on U.S. data with FIML and although the pure forward-looking New-Keynesian Phillips curve is rejected, a version with both forward- and backward-looking components provides a reasonable approximation of U.S. inflation dynamics.     

Monetary Pressures and Inflation Dynamics in Turkey: Evidence from P-Star Model

This paper uses the P-star model to explain inflation dynamics in Turkey. In P-star models, money determines the price gap, which is postulated to measure the pressure on prices in an economy. This pressure emerges when output is above the potential, the interest rate is lower than the natural rate, or there is pure excess money in the economy. The estimation results with the Turkish data show that the price gap contains considerable information for explaining inflation dynamics. Moreover, the model selection criterion that compares the empirical performance of the P-star model with the new classical Phillips curve relation favors the P-star model over the Phillips curve relationship. We conclude that money is efficacious in predicting risk in price stability in Turkey.     

Do expected future marginal costs drive inflation dynamics?

This article discusses a more general interpretation of the two-step minimum distance estimation procedure proposed in Sbordone (2002). The estimator is again applied to a version of the New Keynesian Phillips curve, where inflation dynamics are driven by the expected evolution of marginal costs. The article clarifies econometric issues, addresses concerns about uncertainty and model misspecification raised in recent studies, and assesses the robustness of previous results. While confirming the importance of forward-looking terms in accounting for inflation dynamics, it suggests how the methodology can be applied to extend the analysis of inflation to a multivariate setting.     

Deep Habits in the New Keynesian Phillips Curve

We derive and estimate a New Keynesian Phillips Curve (NKPC) in a model with deep habits. Habits are deep in that they apply to individual consumption goods instead of aggregate consumption. This alters the NKPC in a fundamental manner since it introduces consumption growth and future demand terms into the NKPC equation. We construct the driving process in the deep habits NKPC by using the model's optimality conditions to impute time series for unobservable variables. The resulting series is considerably more volatile than unit labor cost. Generalized methods of moments estimation shows an improved fit and a much lower degree of indexation compared to the standard NKPC.     

Trade openness and inflation: The role of real and nominal price rigidities

The paper revisits the long-standing question of the impact of trade openness on the inflation–output trade-off by accounting for the effects of product market competition on price flexibility. The study develops a New-Keynesian open-economy dynamic stochastic general equilibrium model with non-constant price elasticity of demand and Calvo price setting in which the frequency of price adjustment is endogenously determined. It demonstrates that trade openness has two opposing effects on the sensitivity of inflation to output fluctuations. On the one hand, it raises strategic complementarity in firms' pricing decisions and the degree of real price rigidities, which makes inflation less responsive to changes in real marginal cost. On the other hand, it strengthens firms' incentives to adjust their prices, thereby reducing the degree of nominal price rigidities and increasing the sensitivity of inflation to changes in marginal cost. The study explains the positive relationship between competition and the frequency of price adjustment observed in the data. It also provides new insights into the effects of global economic integration on the Phillips Curve.     

The (ir)relevance of real wage rigidity in the New Keynesian model with search frictions

We develop a New Keynesian model with search and matching frictions in the labor market. We show that the model generates counterfactual labor market dynamics. In particular, it fails to generate the negative correlation between vacancies and unemployment in the data, i.e., the Beveridge curve. Introducing real wage rigidity leads to a negative correlation, and increases the magnitude of labor market flows to more realistic values. However, inflation dynamics are only weakly affected by real wage rigidity. The reason is that labor market frictions give rise to long-run employment relationships. The measure of real marginal costs that is relevant for inflation in the Phillips curve contains a present value component that varies independently of the real wage.     

The Macroeconomic Effects of Nonzero Trend Inflation

We study the macroeconomic effects of nonzero trend inflation in a simple dynamic stochastic general equilibrium model under three common time-dependent pricing schemes: Calvo, truncated-Calvo, and Taylor. We show that, regardless of the pricing mechanism, trend inflation leads to a reduction in the stochastic means of output, consumption and employment, and an increase in the stochastic mean of inflation beyond its deterministic steady-state level. The variability of most aggregates also increases. These effects are quantitatively much stronger with Calvo pricing.     

Dynamic pricing and imperfect common knowledge

Introducing private information into the dynamic pricing decision of firms by adding an idiosyncratic component to marginal cost can help explain two stylised facts about price changes: Aggregate inflation responds gradually and with inertia to shocks at the same time as individual price changes can be large. The inertial behaviour of inflation is driven by privately informed firms strategically ‘herding’ on the public information contained in the observations of lagged aggregate variables. The model also matches the average duration between price changes found in the data and it nests the standard New-Keynesian Phillips Curve as a special case. To solve the model, the paper derives an algorithm for solving a class of dynamic models with higher order expectations.