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New evidence on the output cost of fighting inflation

  • Andrew J. Filardo

The Federal Reserve has made significant progress toward price stability over the last two decades. The annual inflation rate has declined from 13 percent in the early 1980s to roughly 2 percent today. But, to be sure, the current low-inflation environment has come at a price.> One key cost of achieving low inflation is the output loss that generally accompanies a permanent decline in inflation, as occurred in the early 1980s and early 1990s. Another more subtle output cost of fighting inflation is the cost of preventing inflation from rising. As incipient inflation pressures build, tighter monetary policy can slow the economy and thereby preemptively forestall the rise in actual inflation. The slower output growth is the cost of resisting inflation pressures. Together, these two output costs of fighting inflation play important roles in determining how best to maintain low inflation and how to seek further disinflation toward price stability.> A significant factor determining the output cost of fighting inflation is the tradeoff between inflation and output, often referred to as the Phillips curve. Traditionally, estimates of this relationship assume the shape of this curve is linear. This implies that the slope of the Phillips curve is a constant and, therefore, independent of the stage of the business cycle, the speed of the disinflation, and how aggressively incipient inflation pressures are fought. Recent research, however, has begun to question whether the slope is constant. Assessing the output cost of fighting inflation may be more complicated than traditionally assumed.> Filardo investigates the shape of the Phillips curve and the associated output cost of fighting inflation. He concludes that, while the Phillips curve traditionally has been thought of as approximately linear, closer examination of the inflation-output relationship reveals important nonlinearities. This new evidence and its implications for the output cost of fighting inflation may require new policy strategies.

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Article provided by Federal Reserve Bank of Kansas City in its journal Economic Review.

Volume (Year): (1998)
Issue (Month): Q III ()
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Handle: RePEc:fip:fedker:y:1998:i:qiii:n:v.83no.3
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