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The New Keynesian Model and the Long-Run Vertical Phillips Curve: Does It Hold for Germany?

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  • Jan Gottschalk
  • Ulrich Fritsche

Abstract

New-Keynesian macroeconomic models typically assume that any long-run trade-off between inflation and unemployment is ruled out. While this appears to be a reasonable characterization of the US economy, it is less clear that the natural rate hypothesis necessarily holds in a European country like Germany where hysteretic effects may invalidate it. Inspired by the framework developed by Farmer (2000) and Beyer and Farmer (2002), we investigate the long-run relationships between the interest rate, unemployment and inflation in West Germany from the early 1960s up to 2004 using a multivariate co-integration analysis technique. The results point to a structural break in the late 1970s. In the later time period we find for West German data a strong negative correlation between the trend components of inflation and unemployment. We show that this finding contradicts the natural rate hypothesis, introduce a version of the New Keynesian model which allows for some hysteresis and compare the effectiveness of monetary policy in these two models. In general, a policy rule with an aggressive response to a rise in unemployment performs better in a model with hysteretic characteristics than in a model without.

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File URL: http://www.diw.de/documents/publikationen/73/diw_01.c.43776.de/dp521.pdf
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Bibliographic Info

Paper provided by DIW Berlin, German Institute for Economic Research in its series Discussion Papers of DIW Berlin with number 521.

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Length: 47 p.
Date of creation: 2005
Date of revision:
Handle: RePEc:diw:diwwpp:dp521

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Keywords: Cointegration; Vector error correction model; Unemployment; Phillips curve; Hysteresis;

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Citations

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Cited by:
  1. Steffen Ahrens, Dennis Snower, 2012. "Envy, Guilt, and the Phillips Curve," Kiel Working Papers 1754, Kiel Institute for the World Economy.
  2. Kitov, Ivan, 2007. "Exact prediction of inflation and unemployment in Germany," MPRA Paper 5088, University Library of Munich, Germany.
  3. Ulrich Fritsche & Vladimir Kuzin, 2007. "Unit Labor Cost Growth Differentials in the Euro Area, Germany, and the US: Lessons from PANIC and Cluster Analysis," Discussion Papers of DIW Berlin 667, DIW Berlin, German Institute for Economic Research.
  4. Kienzler, Daniel & Schmid, Kai D., . "Monetary Policy and Hysteresis in Potential Output," Working Papers on Finance 1328, University of St. Gallen, School of Finance.

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