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Optimal Inflation and the Identification of the Phillips Curve

In: NBER Macroeconomics Annual 2019, volume 34

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  • Michael McLeay
  • Silvana Tenreyro

Abstract

Several academics and practitioners have pointed out that inflation follows a seemingly exogenous statistical process, unrelated to the output gap, leading some to argue that the Phillips curve has weakened or disappeared. In this paper, we explain why this seemingly exogenous process arises, or, in other words, why it is difficult to empirically identify a Phillips curve, a key building block of the policy framework used by central banks. We show why this result need not imply that the Phillips curve does not hold—on the contrary, our conceptual framework is built under the assumption that the Phillips curve always holds. The reason is simple: if monetary policy is set with the goal of minimizing welfare losses (measured as the sum of deviations of inflation from its target and output from its potential), subject to a Phillips curve, a central bank will seek to increase inflation when output is below potential. This targeting rule will impart a negative correlation between inflation and the output gap, blurring the identification of the (positively sloped) Phillips curve. We discuss different strategies to circumvent the identification problem and present evidence of a robust Phillips curve in US data.
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  • Michael McLeay & Silvana Tenreyro, 2019. "Optimal Inflation and the Identification of the Phillips Curve," NBER Chapters, in: NBER Macroeconomics Annual 2019, volume 34, pages 199-255, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberch:14245
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    4. Hooper, Peter & Mishkin, Frederic S. & Sufi, Amir, 2020. "Prospects for inflation in a high pressure economy: Is the Phillips curve dead or is it just hibernating?," Research in Economics, Elsevier, vol. 74(1), pages 26-62.
    5. Chiara Fratto & Harald Uhlig, 2020. "Accounting for Post-Crisis Inflation: A Retro Analysis," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 35, pages 133-153, January.
    6. John Komlos, 2019. "The Real U.S. Unemployment Rate Is Twice the Official Rate, and the Phillips Curve," CESifo Working Paper Series 7859, CESifo.
    7. Òscar Jordà & Fernanda Nechio, 2020. "Inflation Globally," Central Banking, Analysis, and Economic Policies Book Series, in: Gonzalo Castex & Jordi Galí & Diego Saravia (ed.),Changing Inflation Dynamics,Evolving Monetary Policy, edition 1, volume 27, chapter 8, pages 269-316, Central Bank of Chile.
    8. Kristen Tauber & Willem Van Zandweghe, 2020. "A Growth-Augmented Phillips Curve," Economic Commentary, Federal Reserve Bank of Cleveland, vol. 2020(16), pages 1-6, July.
    9. Sebastião Abreu, Daniel & Silva Lopes, Artur, 2019. "How to disappear completely: non-linearity and endogeneity in the new keynesian wage Phillips curve," MPRA Paper 94591, University Library of Munich, Germany.
    10. Del Negro, Marco & Lenza, Michele & Primiceri, Giorgio & Tambalotti, Andrea, 2020. "Why has inflation in the United States been so stable since the 1990s?," Research Bulletin, European Central Bank, vol. 74.
    11. James H. Stock & Mark W. Watson, 2019. "Slack and Cyclically Sensitive Inflation," NBER Working Papers 25987, National Bureau of Economic Research, Inc.
    12. Ortega, Eva & Osbat, Chiara, 2020. "Exchange rate pass-through in the euro area and EU countries," Occasional Paper Series 241, European Central Bank.
    13. Bańbura, Marta & Bobeica, Elena, 2020. "Does the Phillips curve help to forecast euro area inflation?," Working Paper Series 2471, European Central Bank.
    14. Böhl, Gregor & Lieberknecht, Philipp, 2021. "The hockey stick Phillips curve and the zero lower bound," IMFS Working Paper Series 153, Goethe University Frankfurt, Institute for Monetary and Financial Stability (IMFS).
    15. Frohm, Erik, 2020. "Price-setting and economic slack: Evidence from firm-level survey data," Journal of Macroeconomics, Elsevier, vol. 65(C).
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    More about this item

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C23 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Models with Panel Data; Spatio-temporal Models

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