Technology,Utilization, and Inflation: What Drives the New Keynesian Phillips Curve?

We argue that the New Keynesian Phillips Curve literature has failed to deliver a convincing measure of real marginal costs. We start from a careful modeling of optimal price setting allowing for nonunitary factor substitution, nonneutral technical change, and time‐varying factor utilization rates. This ensures the resulting real marginal cost measures match volatility reductions and level changes witnessed in many U.S. time series. The cost measure comprises conventional countercyclical cost elements plus procyclical (and covarying) utilization rates. Although procyclical elements seem to dominate, the components of real marginal cost components are becoming less cyclical over time. Incorporating this richer driving variable produces more plausible price‐stickiness estimates than otherwise and suggests a more balanced weight of backward‐ and forward‐looking inflation expectations than commonly found. Our results challenge existing views of inflation determinants and have important implications for modeling inflation in New Keynesian models.     

The case for inflation stability

We evaluate the case for inflation stabilization in a New Keynesian (NNS) model that includes various frictions, capital accumulation and a variety of shocks. In such a model, price rigidity may provide the monetary authorities with an opportunity to improve upon the inefficient flexible price equilibrium via the suitable cyclical manipulation of real marginal costs. We find that such an opportunity is of limited value and that a strong case for perfect inflation stabilization remains. Policies that tolerate a small amount of inflation variability may outperform perfect inflation targeting when capital adjustment costs are low and the monetary distortion is substantial but only if prices are very flexible.     

Similar GDP-inflation cycles. An application to CEE countries and the euro area

In this paper we look at business cycles similarities between CEE countries and the euro area. Particularly, we uncover GDP-inflation cycles by adopting a trend-cycle decomposition model which allows the trend to be either stochastic or deterministic, i.e. of the non-linear type. Once cyclical components are derived, we test for ex post restrictions at both with-in (GDP-to-inflation) and cross-country (CEECs vs. euro area) levels. Allowing for different degrees of cyclical similarity, we find that a similar inflation vs. GDP cycle is not rejected only for Poland, Lithuania, Romania and Estonia (with Latvia and the euro area being at the boundary). Looking at cross-country results, almost all countries feature a fair degree of similarity with respect to the euro area. Exceptions are Poland, Hungary, Latvia and Slovenia because of lack of a similar cycle either occurring in GDP or inflation, yet not in both. Finally, observing how concurrence between each CEECs cycle and the euro area evolved over time, we find that inflation conditional correlation increased stemming from the EU accession of most CEECs and as a result of the commodity price shock preceding 2008. Further, inflation and GDP conditional correlations receded during the course of 2009–2010, possibly resulting from more idiosyncratic adjustments in the aftermath of the crisis on the monetary/fiscal side. Interestingly, Slovenia, Slovakia, Estonia and Bulgaria display a conditional correlation pattern in GDP and inflation which roughly suggest a strong out-of-phase recovery starting from 2005.     

The Cyclical Reaction of Fiscal Policies in the Euro Area: The Role of Modelling Choices and Data Vintages*

We survey the recent empirical literature concerning the cyclical response of fiscal policies in the euro area, finding large differences in results. We show that these differences are heavily influenced by the choices made in modelling fiscal behaviour. We make a case for the use, in assessing policies and in the EMU context, of the standard modelling choice where the discretionary reaction of fiscal policy is directly estimated. Models where the overall reaction to the cycle – which includes the effects of both discretionary actions and automatic stabilisers – is directly estimated tend to suggest either strong pro‐cyclical or strong counter‐cyclical discretionary reactions, depending on how this component is identified. Within the standard model and for the years 1994 to 2008, we show that results are significantly affected by the data vintage (ex post or real‐time). With ex post data, we find an unambiguous indication of a‐cyclicality. Using real‐time data, we find that the output gap matters. However, depending on whether we assess policy intentions or actual policies, euro‐area governments' behaviour radically changes. A plausible interpretation is that in the implementation phase, governments loosen their fiscal stance, giving in to political pressures that are proportional to the scale of the economic difficulties in bad times and the size of the ‘growth dividend’ in good times.     

Inflation dynamics with search frictions: A structural econometric analysis

The New Keynesian Phillips curve explains inflation dynamics as being driven by current and expected future real marginal costs. In competitive labor markets, the labor share can serve as a proxy for the latter. In this paper, we study the role of real marginal cost components implied by search frictions in the labor market. We construct a measure of real marginal costs by using newly available labor market data on worker finding rates. Over the business cycle, the measure is highly correlated with the labor share. Estimates of the Phillips curve using generalized method of moments reveal that the marginal cost measure remains significant, and that inflation dynamics are mainly driven by the forward-looking component. Bayesian estimation of the full New Keynesian model with search frictions helps us disentangle which shocks are driving the economy to generate the observed unit labor cost dynamics. We find that mark-up shocks are the dominant force in labor market fluctuations.     

Measuring Inflation Expectations Uncertainty Using High‐Frequency Data

Inflation expectations play a key role in determining future economic outcomes. The associated uncertainty provides a direct gauge of how well‐anchored the inflation expectations are. We construct a model‐based measure of inflation expectations uncertainty by augmenting a standard unobserved components model of inflation with information from noisy and possibly biased measures of inflation expectations obtained from financial markets. This new model‐based measure of inflation expectations uncertainty is more accurately estimated and can provide valuable information for policymakers. Using U.S. data, we find significant changes in inflation expectations uncertainty during the Great Recession.     

In search of the natural rate of unemployment

The natural rate of unemployment can be measured as the time-varying steady state of a structural vector autoregression. For post-War US data, the natural rate implied by this approach is more volatile than most previous estimates, with its movements accounting for the bulk of the variation in the unemployment rate, as well as substantial portions of the variation in aggregate output and inflation. These movements, in turn, can be related to variables associated with labor-market search theory, including unemployment benefits, labor productivity, real wages, and sectoral shifts in the labor market. There is also a strong negative relationship between inflation and the corresponding measure of cyclical unemployment, supporting the existence of a short-run Phillips curve.     

Inflation and Asset Returns in a Monetary Economy

Postwar U.S. data are characterized by negative correlations between real equity returns and inflation and by positive correlations between real equity returns and money growth. These patterns are closely matched quantitatively by an equilibrium monetary asset pricing model. The model also implies negative correlations between expected asset returns and expected inflation, and it predicts that the inflation-asset return correlation will be more strongly negative when inflation is generated by fluctuations in real economic activity than when it is generated by monetary fluctuations.     

The Impact of Inflation Measures on the Real Returns and Risk of U.S. Stocks

Using different inflation measures produces economically significant differences in both the inflation record and inflation‐adjusted stock returns. We introduce a more consistent measure of the monthly Consumer Price Index (CPI) inflation rate to better measure real returns over 1913–2004, for which the official CPI exists. We also extend the series backward to 1871 on a monthly basis, an important addition to the data series. We analyze the impact of inflation on the real standard deviation of stock returns and find that, in contrast to the results for geometric mean returns, inflation adjustments have little impact on estimates of return variability.     

Explaining international stock correlations with CPI fluctuations and market volatility

This paper investigates the dynamic correlations among six international stock market indices and their relationship to inflation fluctuation and market volatility. The current research uses a newly developed time series model, the Double Smooth Transition Conditional Correlation with Conditional Auto Regressive Range (DSTCC-CARR) model. Findings reveal that international stock correlations are significantly time-varying and the evolution among them is related to cyclical fluctuations of inflation rates and stock volatility. The higher/lower correlations emerge between countries when both countries experience a contractionary/expansionary phase or higher/lower volatilities.     

The Term Structure of Real Rates and Expected Inflation

Changes in nominal interest rates must be due to either movements in real interest rates, expected inflation, or the inflation risk premium. We develop a term structure model with regime switches, time‐varying prices of risk, and inflation to identify these components of the nominal yield curve. We find that the unconditional real rate curve in the United States is fairly flat around 1.3%. In one real rate regime, the real term structure is steeply downward sloping. An inflation risk premium that increases with maturity fully accounts for the generally upward sloping nominal term structure.     

Optimal Monetary Policy with Labor Market Frictions: The Role of the Wage Channel

This paper introduces right‐to‐manage bargaining into a labor search model with sticky prices instead of standard efficient bargaining and examines the Ramsey‐optimal monetary policy. Without real wage rigidity, even when the steady state is inefficient, price stability is nearly optimal in response to technology or government shocks. Right‐to‐manage bargaining creates the wage channel to inflation, because there is a direct relationship between real wages and real marginal cost. In the presence of the wage channel, price markups consist of only real marginal cost, and real wages and hours per worker are determined such as in the Walrasian labor market.     

Industry Returns and the Fisher Effect

We investigate the cross-sectional relation between industry-sorted stock returns and expected inflation, and we find that this relation is linked to cyclical movements in industry output. Stock returns of noncyclical industries tend to covary positively with expected inflation, while the reverse holds for cyclical industries. From a theoretical perspective, we describe a model that captures both (i) the cross-sectional variation in these relations across industries, and (ii) the negative and positive relation between stock returns and inflation at short and long horizons, respectively. The model is developed in an economic environment in which the spirit of the Fisher model is preserved.     

Stock returns,velocity dynamics and inflation volatility

ABSTRACT

Our model relates the variability of stock returns to the variability of consumption velocity and shows that real stock returns tend to co-vary negatively with expected inflation in a period (or regime) of low and stable inflation and to co-vary positively with expected inflation in a period (or regime) of high and volatile inflation. Long-run real stock returns are shown to be positively related to expected inflation. Our empirical results for 20 countries provide consistent support for our propositions, indicating that the standard deviation of the annual inflation rate roughly equal to 10% is the dividing line between negative and positive return-inflation relations.     

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.     

Gauging exchange rate targeting

In this paper, we examine whether a monetary authority targets the exchange rate, per se, or instead simply appears to do so as it responds to the exchange rate and other variables in service to inflation and output targets. We combine data-rich estimation with a system of forward-looking equations in order to disentangle the possibilities. The combined approach reveals the potentially misleading nature of standard estimates of the extent of exchange rate and inflation targeting. We illustrate the approach by applying it to two de jure inflation targetters, Canada and Korea. In contrast to standard methods and much past work, we find that neither country targets its exchange rate; and, both are bona fide inflation targetters.     

Trends and random walks in macroeconmic time series: Some evidence and implications

This paper investigates whether macroeconomic time series are better characterized as stationary fluctuations around a deterministic trend or as non-stationary processes that have no tendency to return to a deterministic path. Using long historical time series for the U.S. we are unable to reject the hypothesis that these series are non-stationary stochastic processes with no tendency to return to a trend line. Based on these findings and an unobserved components model for output that decomposes fluctuations into a secular or growth component and a cyclical component we infer that shocks to the former, which we associate with real disturbances, contribute substantially to the variation in observed output. We conclude that macroeconomic models that focus on monetary disturbances as a source of purely transitory fluctuations may never be successful in explaining a large fraction of output variation and that stochastic variation due to real factors is an essential element of any model of macroeconomic fluctuations.     

Real Interest Rates and Inflation: An Ex-Ante Empirical Analysis

We develop a method of measuring ex-ante real interest rates using prices of index and nominal bonds. Employing this method and newly available data, we directly test the Fisher hypothesis that the real rate of interest is independent of inflation expectations. We find a negative correlation between ex-ante real interest rates and expected inflation. This contradicts the Fisher hypothesis but is consistent with the theories of Mundell and Tobin, Darby and Feldstein, and Stulz. We also find that nominal interest rates include an inflation risk premium that is positively related to a proxy for inflation uncertainty.     

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.     

General equilibrium pricing of CPI derivatives

We examine the issue of pricing forward futures and option contracts written on the Consumer Price Index (CPI), the change of which is a measure of inflation affecting the economy. Traditional approaches postulate an exogenous process for the price level and then derive CPI derivatives prices by standard arbitrage arguments. By contrast, we build the general equilibrium of a continuous time monetary economy that is affected by both real and nominal shocks. The price level and thus the inflation rate are found endogenously and solutions for the prices of CPI derivatives are obtained, which are in closed form in a specialized version of the economy.