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Expectation horizon and the Phillips Curve: the solution to an empirical puzzle

  • Charles R. Nelson

    (Department of Economics, University of Washington, Seattle, Washington, USA)

  • Jaejoon Lee

    (Samsung Research Institute of Finance, Seoul, Korea)

Estimates of the slope of the Phillips curve reported in the literature cover a range from roughly − 0.6 to zero depending on specification. Forward-looking specifications, favored by theory, produce the smallest slope estimates. This paper addresses this puzzle by studying the bivariate process of inflation and unemployment in a fairly general unobserved components framework allowing for stochastic trends and related cycles. Analysis reveals that the slope of the implied Phillips curve will depend critically on the horizon of the forward-looking inflation expectation provided the cyclical component of unemployment is highly persistent. Empirical analysis results show that is the case, suggesting that the choice of expectation horizon, generally set at one quarter in the New Keynesian literature, may play an important role in this debate. Copyright © 2007 John Wiley & Sons, Ltd.

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Article provided by John Wiley & Sons, Ltd. in its journal Journal of Applied Econometrics.

Volume (Year): 22 (2007)
Issue (Month): 1 ()
Pages: 161-178

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Handle: RePEc:jae:japmet:v:22:y:2007:i:1:p:161-178
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  1. Thomas Laubach, 1997. "Measuring the NAIRU : evidence from seven economies," Research Working Paper 97-13, Federal Reserve Bank of Kansas City.
  2. James C. Morley & Charles Nelson & Eric Zivot, 2000. "Why Are Beveridge-Nelson and Unobserved-Component Decompositions of GDP So Different?," Discussion Papers in Economics at the University of Washington 0013, Department of Economics at the University of Washington.
  3. Arturo Estrella & Jeffrey C. Fuhrer, 2002. "Dynamic Inconsistencies: Counterfactual Implications of a Class of Rational-Expectations Models," American Economic Review, American Economic Association, vol. 92(4), pages 1013-1028, September.
  4. Gali, Jordi & Gertler, Mark, 1999. "Inflation dynamics: A structural econometric analysis," Journal of Monetary Economics, Elsevier, vol. 44(2), pages 195-222, October.
  5. Robert G. King & Mark W. Watson, 1994. "The post-war U.S. Phillips curve: a revisionist econometric history," Working Paper Series, Macroeconomic Issues 94-14, Federal Reserve Bank of Chicago.
  6. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
  7. Roberts, John M, 1995. "New Keynesian Economics and the Phillips Curve," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(4), pages 975-84, November.
  8. Jeffrey C. Fuhrer, 1995. "The Phillips curve is alive and well," New England Economic Review, Federal Reserve Bank of Boston, issue Mar, pages 41-56.
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