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The New Keynesian Model and the Long-Run Vertical Phillips Curve: Does It Hold for Germany?

  • Jan Gottschalk
  • Ulrich Fritsche

New-Keynesian macroeconomic models typically assume that any long-run trade-off between inflation and unemployment is ruled out. While this appears to be a reasonable characterization of the US economy, it is less clear that the natural rate hypothesis necessarily holds in a European country like Germany where hysteretic effects may invalidate it. Inspired by the framework developed by Farmer (2000) and Beyer and Farmer (2002), we investigate the long-run relationships between the interest rate, unemployment and inflation in West Germany from the early 1960s up to 2004 using a multivariate co-integration analysis technique. The results point to a structural break in the late 1970s. In the later time period we find for West German data a strong negative correlation between the trend components of inflation and unemployment. We show that this finding contradicts the natural rate hypothesis, introduce a version of the New Keynesian model which allows for some hysteresis and compare the effectiveness of monetary policy in these two models. In general, a policy rule with an aggressive response to a rise in unemployment performs better in a model with hysteretic characteristics than in a model without.

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File URL: http://www.diw.de/documents/publikationen/73/diw_01.c.43776.de/dp521.pdf
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Paper provided by DIW Berlin, German Institute for Economic Research in its series Discussion Papers of DIW Berlin with number 521.

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Length: 47 p.
Date of creation: 2005
Date of revision:
Handle: RePEc:diw:diwwpp:dp521
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