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Phillips curve instability and optimal monetary policy

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  • Troy Davig

Abstract

This paper assesses the implications for optimal discretionary monetary policy if the slope of the Phillips curve changes. The paper first derives a ?switching? Phillips curve from the optimal pricing decision of a monopolistic firm that faces a changing cost of price adjustment. Two states exists, a state with a high cost of price adjustment that generates a ?flat? Phillips curve and a low-cost state that generates a relatively ?steep? curve. The second aspect of the paper constructs a utility-based welfare criterion. A novel feature of this criterion is that it has a relative weight on output gap deviations that is state dependent, so it changes with the cost of price adjustment. Optimal monetary policy is computed subject to the switching-Phillips curve under both ad-hoc and utility-based welfare criteria. The utility-based criterion instructs monetary policy to disregard the slope of the Phillips curve and keep its systematic actions constant across different states. This stands in contrast to the prescription coming under the ad-hoc criterion, which advises monetary policy to change its systematic behavior according to the slope of the Phillips curve.

Suggested Citation

  • Troy Davig, 2007. "Phillips curve instability and optimal monetary policy," Research Working Paper RWP 07-04, Federal Reserve Bank of Kansas City.
    • Handle: RePEc:fip:fedkrw:rwp07-04
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    File URL: https://www.kansascityfed.org/documents/7690/rwp07-04.pdf
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    Cited by:

    1. Troy Davig & Eric M. Leeper, 2010. "Generalizing the Taylor Principle: Reply," American Economic Review, American Economic Association, vol. 100(1), pages 618-624, March.
    2. Troy Davig & Eric Leeper, 2009. "Reply To “Generalizing The Taylor Principle: A Comment”," CAEPR Working Papers 2009-008, Center for Applied Economics and Policy Research, Department of Economics, Indiana University Bloomington.
    3. Jason Choi & Andrew Foerster, 2021. "Optimal Monetary Policy Regime Switches," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 42, pages 333-346, October.
    4. Jisheng Yang, 2010. "Expectation, excess liquidity and inflation dynamics in China," Frontiers of Economics in China, Springer;Higher Education Press, vol. 5(3), pages 412-429, September.
    5. Nicholas Apergis, 2024. "Eurozone inflation: fresh projections from global factors," Economics and Business Letters, Oviedo University Press, vol. 13(1), pages 39-47.
    6. Marian Vavra, 2013. "Testing for linear and Markov switching DSGE models," Working and Discussion Papers WP 3/2013, Research Department, National Bank of Slovakia.
    7. Filippo Occhino, 2019. "The Flattening of the Phillips Curve: Policy Implications Depend on the Cause," Economic Commentary, Federal Reserve Bank of Cleveland, issue July.
    8. Seonghoon Cho, 2016. "Sufficient Conditions for Determinacy in a Class of Markov-Switching Rational Expectations Models," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 21, pages 182-200, July.
    9. Wagner, Joel & Schlanger, Tudor & Zhang, Yang, 2023. "A horse race of alternative monetary policy regimes under bounded rationality," Journal of Economic Dynamics and Control, Elsevier, vol. 154(C).
    10. Aristidou, Chrystalleni, 2018. "The meta-Phillips Curve: Modelling U.S. inflation in the presence of regime change," Journal of Macroeconomics, Elsevier, vol. 57(C), pages 367-379.
    11. Guido Bulligan & Eliana Viviano, 2017. "Has the wage Phillips curve changed in the euro area?," IZA Journal of Labor Policy, Springer;Forschungsinstitut zur Zukunft der Arbeit GmbH (IZA), vol. 6(1), pages 1-22, December.
    12. Gasteiger, Emanuel & Grimaud, Alex, 2023. "Price setting frequency and the Phillips curve," European Economic Review, Elsevier, vol. 158(C).

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    Keywords

    Phillips curve; Monetary policy;

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