Inflation dynamics, marginal cost, and the output gap: evidence from three countries

Recent studies by Gal and Gertler (1999), Gal, Gertler, and Lpez-Salido (GGL) (2001a, 2001b), and Sbordone (1998, 2001) have argued that the New Keynesian Phillips curve (Calvo pricing model) is empirically valid, provided that real marginal cost rather than detrended output is used as the variable driving inflation. GGL (2001a) conclude that real marginal cost is not closely related to the output gap, and that models for monetary policy therefore need to include labor market rigidities. An alternative interpretation is that marginal cost and the output gap are closely related, but that the latter needs to be measured in a manner consistent with dynamic general equilibrium models. To date, there has been little econometric investigation of this alternative interpretation. This paper provides estimates of the New Keynesian Phillips curve for the United States, the United Kingdom, and Australia using theory-based estimates of the output gap. We find little support for the notion that labor costs explain inflation dynamics better than the output gap, and so conclude that modeling of labor market rigidities is not a high priority in analyzing inflation.