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On the Generality of the New Keynesian Phillips Curves

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  • Maritta Paloviita

    (Bank of Finland)

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    Abstract

    The New Keynesian Phillips curve is widely used in macroeconomics and monetary policy analysis. It is explicitly based on micro-foundations, monopolistically competitive firms and sticky prices. In its original form the New Keynesian Phillips curve is purely forward-looking model of inflation dynamics in the closed economy context. It is based on time-contingent price setting, which can be derived using Taylor’s overlapping contracts model (Taylor 1980), Rotemberg’s model of quadratic costs of price adjustment (Rotemberg 1982) or the Calvo (1983) model with random price adjustment. The alternative New Keynesian Hybrid Phillips curve includes elements of both forward- and backward-looking prices setting (Galí and Gertler, 1999). In the hybrid model only some price setters behave optimally when adjusting prices while the rest use rules of thumb or indexation, which is based on recent history of aggregate prices. When the New Keynesian Phillips curve is extended into open economy framework, inflation dynamics become more complicated, as new channels arise due to exchange rate changes and the effects of foreign shocks. In this approach, not only domestic demand and supply, but also foreign economic conditions influence domestic inflation. Imported goods can be modelled as intermediate goods (McCallun and Nelson, 1999, 2000; Kara and Nelson, 2003; Allsopp, Kara and Nelson, 2006), or as final consumption goods (Galí and Monacelli, 2005). Also more complicated models have been investigated (Batini et al, 2005; Leith and Malley, 2007; Rumler, 2007). The exchange rate pass-through is assumed to be full when final consumption goods model is analysed, but incomplete when imported goods are treated as intermediate goods. In this study we examine the empirical relevance of the New Keynesian Phillips curve relationship. Using pooled data for the euro area since the late 1980s, we compare the empirical fit of alternative Phillips curve specifications. We investigate both purely forward-looking models and hybrid models, which include both forwardand backward-looking elements of expectations. In the open economy context, we make the assumption that all imports are intermediate goods. Possible persistence in expectations is taken into account by using direct proxies i.e. Consensus Economics survey data for inflation expectations. The empirical analysis provides the strongest support for the open economy New Keynesian hybrid model. The Wald test of coefficient restrictions suggests that compared with the purely forward-looking specification, euro area inflation dynamics are better captured by the hybrid Phillips curve. Moreover, the empirical performance of the hybrid specification is improved, if the model is extended into open economy context. Robustness analysis indicates that the same open economy hybrid model is appropriate for countries with low and with high output gap volatility. Moreover, the inflation process in the four biggest and in the rest of the countries can be modelled using the same model parameters. Inflation dynamics are a central issue in monetary policy analysis. When conducting monetary policy, the inflation process and the effects of foreign shocks (for example energy and food price shocks) on domestic inflation must be carefully analysed. It is also important to examine how persistent the effects of shocks on inflation are and how the exchange rate and inflation are related. Overall, monetary policy analysis must be based on structural models, which capture expectations dynamics and the open economy aspects of the inflation process accurately. Recently, due to sharply weakening conditions in the world economy and highly volatile commodity prices, maintaining a deep understanding of inflation dynamics in the open economy context has become even more important for central banks.

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    File URL: http://www.bcra.gov.ar/pdfs/investigaciones/55_Paloviita.pdf
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    Bibliographic Info

    Article provided by Central Bank of Argentina, Economic Research Department in its journal Ensayos Económicos.

    Volume (Year): 1 (2009)
    Issue (Month): 55 (July - September)
    Pages: 7-32

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    Handle: RePEc:bcr:ensayo:v:1:y:2009:i:55:p:7-32

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    Related research

    Keywords: euro area; expectations; inflation; open economy; New Keynesian Phillips curve;

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    References

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    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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    1. Maritta Paloviita, 2009. "Estimating open economy Phillips curves for the euro area with directly measured expectations," New Zealand Economic Papers, Taylor & Francis Journals, vol. 43(3), pages 233-254.
    2. N. Gregory Mankiw & Ricardo Reis, 2002. "Sticky Information Versus Sticky Prices: A Proposal To Replace The New Keynesian Phillips Curve," The Quarterly Journal of Economics, MIT Press, vol. 117(4), pages 1295-1328, November.
    3. Klaus Adam & Mario Padula, 2011. "Inflation Dynamics And Subjective Expectations In The United States," Economic Inquiry, Western Economic Association International, vol. 49(1), pages 13-25, 01.
    4. Fabio Rumler, 2007. "Estimates of the Open Economy New Keynesian Phillips Curve for Euro Area Countries," Open Economies Review, Springer, vol. 18(4), pages 427-451, September.
    5. Evans, George W. & Honkapohja, Seppo, 2002. "Adaptive learning and monetary policy design," Research Discussion Papers 29/2002, Bank of Finland.
    6. N. Gregory Mankiw & Ricardo Reis, 2001. "Sticky Information: A Model of Monetary Nonneutrality and Structural Slumps," NBER Working Papers 8614, National Bureau of Economic Research, Inc.
    7. Rotemberg, Julio J, 1982. "Monopolistic Price Adjustment and Aggregate Output," Review of Economic Studies, Wiley Blackwell, vol. 49(4), pages 517-31, October.
    8. Adam, Klaus, 2003. "Optimal Monetary Policy with Imperfect Common Knowledge," CFS Working Paper Series 2003/12, Center for Financial Studies (CFS).
    9. Christopher D. Carroll, 2001. "The Epidemiology of Macroeconomic Expectations," NBER Working Papers 8695, National Bureau of Economic Research, Inc.
    10. Bennett T McCallum & Edward Nelson, 2001. "Monetary Policy for an Open Economy: An Alternative Framework with Optimising Agents and Sticky Prices," Discussion Papers 05, Monetary Policy Committee Unit, Bank of England.
    11. Galí, Jordi & Gertler, Mark & López-Salido, J David, 2001. "European Inflation Dynamics," CEPR Discussion Papers 2684, C.E.P.R. Discussion Papers.
    12. Milani, Fabio, 2007. "Expectations, learning and macroeconomic persistence," Journal of Monetary Economics, Elsevier, vol. 54(7), pages 2065-2082, October.
    13. Mavroeidis, Sophocles, 2005. "Identification Issues in Forward-Looking Models Estimated by GMM, with an Application to the Phillips Curve," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 37(3), pages 421-48, June.
    14. Campbell Leith & Jim Malley, 2003. "Estimated Open Economy New Keynesian Phillips Curves for the G7," CESifo Working Paper Series 834, CESifo Group Munich.
    15. Maritta Paloviita, 2006. "Inflation Dynamics in the Euro Area and the Role of Expectations," Empirical Economics, Springer, vol. 31(4), pages 847-860, November.
    16. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
    17. McCallum, Bennett T. & Nelson, Edward, 1998. "Nominal Income Targeting in an Open-Economy Optimizing Model," Seminar Papers 644, Stockholm University, Institute for International Economic Studies.
    18. Christopher Allsopp & Amit Kara & Edward Nelson, 2006. "United Kingdom Inflation Targeting and the Exchange Rate," Economic Journal, Royal Economic Society, vol. 116(512), pages F232-F244, 06.
    19. Taylor, John B, 1980. "Aggregate Dynamics and Staggered Contracts," Journal of Political Economy, University of Chicago Press, vol. 88(1), pages 1-23, February.
    20. Paloviita , Maritta, 2005. "Comparing alternative Phillips curve specifications: European results with survey-based expectations," Research Discussion Papers 22/2005, Bank of Finland.
    21. Batini, Nicoletta & Jackson, Brian & Nickell, Stephen, 2005. "An open-economy new Keynesian Phillips curve for the U.K," Journal of Monetary Economics, Elsevier, vol. 52(6), pages 1061-1071, September.
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