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Phillips curve instability and optimal monetary policy

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Troy Davig

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Abstract

This paper assesses the implications for optimal discretionary monetary policy if the slope of the Phillips curve changes. The paper first derives a ‘switching’ Phillips curve from the optimal pricing decision of a monopolistic firm that faces a changing cost of price adjustment. Two states exists, a state with a high cost of price adjustment that generates a ‘flat’ Phillips curve and a low-cost state that generates a relatively ‘steep’ curve. The second aspect of the paper constructs a utility-based welfare criterion. A novel feature of this criterion is that it has a relative weight on output gap deviations that is state dependent, so it changes with the cost of price adjustment. Optimal monetary policy is computed subject to the switching-Phillips curve under both ad-hoc and utility-based welfare criteria. The utility-based criterion instructs monetary policy to disregard the slope of the Phillips curve and keep its systematic actions constant across different states. This stands in contrast to the prescription coming under the ad-hoc criterion, which advises monetary policy to change its systematic behavior according to the slope of the Phillips curve.

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Paper provided by Federal Reserve Bank of Kansas City in its series Research Working Paper with number RWP 07-04.

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Date of creation: 2007
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Handle: RePEc:fip:fedkrw:rwp07-04

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Keywords: Phillips curve ; Monetary policy;

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  4. Hess Chung & Troy Davig & Eric M. Leeper, 2007. "Monetary and Fiscal Policy Switching," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(4), pages 809-842, 06. [Downloadable!] (restricted)
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  19. David Andolfatto & Paul Gomme, 2003. "Monetary Policy Regimes and Beliefs," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 44(1), pages 1-30, February. [Downloadable!] (restricted)
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  20. Andrew Atkeson & Lee E. Ohanian., 2001. "Are Phillips curves useful for forecasting inflation?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 2-11. [Downloadable!]
  21. Troy Davig & Eric M. Leeper, 2005. "Fluctuating Macro Policies and the Fiscal Theory," NBER Working Papers 11212, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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