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Nonlinear Phillips curves, mixing feedback rules and the distribution of inflation and output

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  • Corrado, Luisa
  • Holly, Sean

Abstract

Optimal nominal interest rate rules are usually set assuming that the underlying world is linear. In this paper we consider the performance of optimal rules when the underlying relationship between inflation and the output gap may be nonlinear. In particular if the inflation-output trade off exhibits nonlinearities this will impart a bias to inflation when a linear rule is used. By deriving some analytical results for the higher moments and in particular the skewness of the distribution of output and inflation, we show that the sign of the skewness of the distribution of inflation and output depends upon the nature of the nonlinearity. For the convex modified hyperbolic function used by Chadha et al. (1992) and Schaling (1999) inflation is positively and output negatively skewed. Whereas, if a concave-convex form is used the skewness of inflation and output is reversed. To correct this bias we propose a piecewise linear rule, which can be thought of as an approximation to the nonlinear rule of Schaling (1999). In order to evaluate the relevance of these results, we turn to some illustrative empirical results for the US and the UK. We show that this reduces the bias, but at the expense of an increase in the volatility of the nominal interest rate.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 28 (2003)
Issue (Month): 3 (December)
Pages: 467-492

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Handle: RePEc:eee:dyncon:v:28:y:2003:i:3:p:467-492

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References

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Cited by:
  1. Mayes , David G. & Virén , Matti, 2004. "Asymmetries in the Euro area economy," Research Discussion Papers 9/2004, Bank of Finland.
  2. Huh, Hyeon-seung & Jang, Inwon, 2007. "Nonlinear Phillips curve, sacrifice ratio, and the natural rate of unemployment," Economic Modelling, Elsevier, vol. 24(5), pages 797-813, September.
  3. Tramontana, F. & Gardini, L. & Ferri, P., 2010. "The dynamics of the NAIRU model with two switching regimes," Journal of Economic Dynamics and Control, Elsevier, vol. 34(4), pages 681-695, April.
  4. Hyeon-seung Huh & Hyun Lee & Namkyung Lee, 2009. "Nonlinear Phillips curve, NAIRU and monetary policy rules," Empirical Economics, Springer, vol. 37(1), pages 131-151, September.

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