Unemployment and Inflation: Evidence of a Nonlinear Phillips Curve in the Eurozone

The classical Phillips curve shows a negative relationship between inflation and unemployment. However, various studies have documented temporal positive and negative relationships between inflation and unemployment, leading to strong criticisms against the Phillips curve. In particular, the triangle approach indicates that the nature of the inflation-unemployment nexus is contingent on the source of the shocks, the length of lagged responses, and the policy response. Similarly, the strong linearity assumption on which the Phillips curve rests may have led to its empirical failure. Prior studies have modelled the possibility of threshold effects in the Phillips curve but no study has established the thresholds of when the relationship switches from negative to positive in the eurozone. This paper addresses this limitation using 11 eurozone countries for the period of January 1999 to February 2017. The paper also estimates both short- and long-run Phillips curves for these countries. We found that, by assuming linearity, there exists a Phillips curve in the short and the long run. We also established that the linearity assumption in the classical Phillips curve might be too strong since there is evidence of threshold effects. The thresholds in unemployment were 5.00% and 6.54%. By estimating the Phillips curve using these thresholds, we found that the relationship between inflation and unemployment is only negative when unemployment is lower than 5.00%. The negative relationship turned positive when unemployment was between 5.00% and 6.54%. Inflation and unemployment are unrelated once a threshold of a 6.54% unemployment rate is surpassed. These findings do not only highlight the importance of threshold effects in the Phillips curve, they also shed light on the need to fight unemployment in the eurozone.