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The improbable renaissance of the Phillips curve: The crisis and euro area inflation dynamics

  • Lourdes Acedo Montoya
  • Björn Döhring
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    Why has euro area (core) inflation not fallen further during and after the "great recession"? How different are inflation dynamics across Member States? This paper analyses core inflation dynamics in the euro area and its Member States using a hybrid specification of the Phillips curve. Inflation expectations are directly observed from an expert survey, so no assumptions need to be imposed about expectations formation. The choice of the hybrid Phillips curve framework is vindicated, as the data clearly indicate the relevance of both backward-looking inflation and inflation expectations. The impact of the output gap on core inflation is significant but not large. The combination of stable inflation expectations, sluggish price adjustment and an only moderate impact of the output gap on inflation helps understanding the stability of core inflation despite large and persistent output gaps in the aftermath of the crisis. Although the heterogeneity of Phillips curve relationships across Member States is not large, the exceptionally large output gap caused by the crisis is one driver (among others) of the recently observed inflation differentials in the euro area.

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    Paper provided by Directorate General Economic and Financial Affairs (DG ECFIN), European Commission in its series European Economy - Economic Papers with number 446.

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    Length: 37 pages
    Date of creation: Oct 2011
    Date of revision:
    Handle: RePEc:euf:ecopap:0446
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