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Does Banque de France control inflation and unemployment?

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  • Kitov, Ivan
  • KItov, Oleg

Abstract

We re-estimate statistical properties and predictive power of a set of Phillips curves, which are expressed as linear and lagged relationships between the rates of inflation, unemployment, and change in labour force. For France, several relationships were estimated eight years ago. The change rate of labour force was used as a driving force of inflation and unemployment within the Phillips curve framework. Following the original problem formulation by Fisher and Phillips, the set of nested models starts with a simplistic version without autoregressive terms and one lagged term of explanatory variable. The lag is determined empirically together with all coefficients. The model is estimated using the Boundary Element Method (BEM) with the least squares method applied to the integral solutions of the differential equations. All models include one structural break might be associated with revisions to definitions and measurement procedures in the 1980s and 1990s as well as with the change in monetary policy in 1994-1995. For the GDP deflator, our original model provided a root mean squared forecast error (RMSFE) of 1.0% per year at a four-year horizon for the period between 1971 and 2004. The same RMSFE is estimated with eight new readings obtained since 2004. The rate of CPI inflation is predicted with RMSFE=1.5% per year. For the naive (no change) forecast, RMSFE at the same time horizon is 2.95% and 3.3% per year, respectively. Our model outperforms the naive one by a factor of 2 to 3. The relationships for inflation were successfully tested for cointegration. We have formally estimated several vector error correction (VEC) models for two measures of inflation. In the VAR representation, these VECMs are similar to the Phillips curves. At a four year horizon, the estimated VECMs provide significant statistical improvements on the results obtained by the BEM: RMSFE=0.8% per year for the GDP deflator and ~1.2% per year for CPI. For a two year horizon, the VECMs improve RMSFEs by a factor of 2, with the smallest RMSFE=0.5% per year for the GDP deflator. This study has validated the reliability and accuracy of the linear and lagged relationships between inflation, unemployment, and the change in labour force between 1970 and 2012.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 50239.

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Date of creation: 27 Sep 2013
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Handle: RePEc:pra:mprapa:50239

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Keywords: monetary policy; inflation; unemployment; labour force; Phillips curve; measurement error; forecasting; cointegration; France;

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