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What's happened to the Phillips curve?

  • Flint Brayton
  • John M. Roberts
  • John C. Williams

The simultaneous occurrence in the second half of the 1990s of low and falling price inflation and low unemployment appears to be at odds with the properties of a standard Phillips curve. We find this result in a model in which inflation depends on the unemployment rate, past inflation, and conventional measures of price supply shocks. We show that, in such a model, long lags of past inflation are preferred to short lags, and that with long lags, the NAIRU is estimated precisely but is unstable in the 1990s. Two alternative modifications to the standard Phillips curve restore stability. One replaces the unemployment rate with capacity utilization. Although this change leads to more accurate inflation predictions in the recent period, the predictive ability of the utilization rate is not superior to that of the unemployment rate for the 1955 to 1998 sample as a whole. The second, and preferred, modification augments the standard Phillips curve to include an "error-correction" mechanism involving the markup of prices over trend unit labor costs. With the markup relatively high through much of the 1990s, this channel is estimated to have held down inflation over this period, and thus provides an explanation of the recent low inflation.

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File URL: http://www.federalreserve.gov/pubs/feds/1999/199949/199949pap.pdf
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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 1999-49.

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Date of creation: 1999
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Handle: RePEc:fip:fedgfe:1999-49
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  1. Donald W.K. Andrews & Werner Ploberger, 1992. "Optimal Tests When a Nuisance Parameter Is Present Only Under the Alternative," Cowles Foundation Discussion Papers 1015, Cowles Foundation for Research in Economics, Yale University.
  2. Robert J. Gordon, 1996. "The Time-Varying NAIRU and its Implications for Economic Policy," NBER Working Papers 5735, National Bureau of Economic Research, Inc.
  3. Stock, James H. & Watson, Mark W., 1999. "Forecasting inflation," Journal of Monetary Economics, Elsevier, vol. 44(2), pages 293-335, October.
  4. Douglas Staiger & James H. Stock & Mark W. Watson, 1996. "How Precise are Estimates of the Natural Rate of Unemployment?," NBER Working Papers 5477, National Bureau of Economic Research, Inc.
  5. Robert J. Gordon, 1998. "Foundations of the Goldilocks Economy: Supply Shocks and the Time-Varying NAIRU," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(2), pages 297-346.
  6. Christina D. Romer & David H. Romer, 1997. "Reducing Inflation: Motivation and Strategy," NBER Books, National Bureau of Economic Research, Inc, number rome97-1.
  7. 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.
  8. Donald W.K. Andrews & Inpyo Lee & Werner Ploberger, 1992. "Optimal Changepoint Tests for Normal Linear Regression," Cowles Foundation Discussion Papers 1016, Cowles Foundation for Research in Economics, Yale University.
  9. Douglas Staiger & James H. Stock & Mark W. Watson, 1997. "The NAIRU, Unemployment and Monetary Policy," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 33-49, Winter.
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