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The Canadian Phillips Curve and Regime Shifting

  • Frédérick Demers

Phillips curves are generally estimated under the assumption of linearity and parameter constancy. Linear models of inflation, however, have recently been criticized for their poor forecasting performance. The author investigates the linearity and constancy assumptions of a standard reduced-form Phillips curve for Canada using two different techniques: (i) the methodology proposed by Bai and Perron (1998), which allows for an unknown number of breaks at unknown dates, and (ii) a three-regimes Markov-switching regression model. Both methodologies strongly reject the linearity and parameter constancy assumptions. The author finds that the output-inflation relationship does not hold under the current monetary policy of inflation targeting, with its low and stable inflation. Since the inflation-control targets were adopted, inflation expectations appear to be more forward looking and well anchored at 2 per cent, the official target rate. Core inflation exhibits very low persistence and there do not appear to be significant asymmetries in the inflation response to output-gap shocks within regimes. Generalized impulse responses are computed to illustrate some properties of the Markov-switching Phillips curve model.

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Paper provided by Bank of Canada in its series Working Papers with number 03-32.

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Length: 34 pages
Date of creation: 2003
Date of revision:
Handle: RePEc:bca:bocawp:03-32
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  1. Jean-François Fillion & André Léonard, 1997. "La courbe de Phillips au Canada : un examen de quelques hypothèses," Working Papers 97-3, Bank of Canada.
  2. Eliasson, Ann-Charlotte, 1999. "Is the short-run Phillips curve nonlinear? Empirical evidence for Australia, Sweden and the United States," SSE/EFI Working Paper Series in Economics and Finance 330, Stockholm School of Economics.
  3. Christopher Sims & Tao Zha, 2002. "Macroeconomic switching," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  4. Gabriel Rodriguez, 2001. "Estimation of the Taylor Rule for Canada Under Multiple Structural Changes," Working Papers 0107E, University of Ottawa, Department of Economics.
  5. Ball, L. & Mankiw, N.G., 1992. "Asymmetric Price Adjustment and Economic Fluctuations," Harvard Institute of Economic Research Working Papers 1602, Harvard - Institute of Economic Research.
  6. Anindya Banerjee & Robin L. Lumsdaine & James H. Stock, 1990. "Recursive and Sequential Tests of the Unit Root and Trend Break Hypothesis: Theory and International Evidence," NBER Working Papers 3510, National Bureau of Economic Research, Inc.
  7. Orphanides, Athanasios & van Norden, Simon, 2005. "The Reliability of Inflation Forecasts Based on Output Gap Estimates in Real Time," CEPR Discussion Papers 4830, C.E.P.R. Discussion Papers.
  8. Hansen, Bruce E, 1992. "The Likelihood Ratio Test under Nonstandard Conditions: Testing the Markov Switching Model of GNP," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 7(S), pages S61-82, Suppl. De.
  9. Garcia, R. & Perron, P., 1994. "An Analysis of the Real Interest rate Under Regime Shifts," Cahiers de recherche 9428, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
  10. Donald W.K. Andrews, 1990. "Tests for Parameter Instability and Structural Change with Unknown Change Point," Cowles Foundation Discussion Papers 943, Cowles Foundation for Research in Economics, Yale University.
  11. 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.
  12. Zivot, Eric & Andrews, Donald W K, 2002. "Further Evidence on the Great Crash, the Oil-Price Shock, and the Unit-Root Hypothesis," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(1), pages 25-44, January.
  13. Clark, Todd E. & McCracken, Michael W., 2006. "The Predictive Content of the Output Gap for Inflation: Resolving In-Sample and Out-of-Sample Evidence," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(5), pages 1127-1148, August.
  14. Robert B. Davies, 2002. "Hypothesis testing when a nuisance parameter is present only under the alternative: Linear model case," Biometrika, Biometrika Trust, vol. 89(2), pages 484-489, June.
  15. Ruge-Murcia, Francisco J, 1995. "Credibility and Changes in Policy Regime," Journal of Political Economy, University of Chicago Press, vol. 103(1), pages 176-208, February.
  16. Michael P. Clements & David F. Hendry, 2001. "Forecasting Non-Stationary Economic Time Series," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262531895, June.
  17. Perron, P. & Bai, J., 1995. "Estimating and Testing Linear Models with Multiple Structural Changes," Cahiers de recherche 9552, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
  18. Nicholas Rowe, 2002. "How to Improve Inflation Targeting at the Bank of Canada," Working Papers 02-23, Bank of Canada.
  19. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-84, March.
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