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Hornstein, Andreas. "Evolving inflation dynamics and the New Keynesian Phillips Curve." Economic Quarterly. Federal Reserve Bank of Richmond. 2007. HighBeam Research. 27 Apr. 2018 <https://www.highbeam.com>.
Hornstein, Andreas. "Evolving inflation dynamics and the New Keynesian Phillips Curve." Economic Quarterly. 2007. HighBeam Research. (April 27, 2018). https://www.highbeam.com/doc/1G1-176588100.html
Hornstein, Andreas. "Evolving inflation dynamics and the New Keynesian Phillips Curve." Economic Quarterly. Federal Reserve Bank of Richmond. 2007. Retrieved April 27, 2018 from HighBeam Research: https://www.highbeam.com/doc/1G1-176588100.html
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In most industrialized economies, periods of above average inflation tend to be associated with above average economic activity, for example, as measured by a relatively low unemployment rate. This statistical relationship, known as the Phillips curve, is sometimes invoked when economic commentators suggest that monetary policy should not try to suppress signs of inflation. But this interpretation of the Phillips curve implicitly assumes that the statistical relationship is structural, that is, the relationship will not break down during periods of persistently high inflation. Starting in the mid-1960s, Friedman and Phelps argued that the Phillips curve is indeed not structural and the experience of the United States and other countries with high inflation and low GDP growth in the late 1960s and 1970s has subsequently borne out their predictions.
Various theories have been proposed to explain the Phillips curve and most of these theories agree that there is no significant long-term tradeoff between inflation and the level of economic activity. One theory that provides a structural interpretation of the short-term inflation-unemployment relationship, and that has become quite popular over the last ten years among central bank economists is based on explicit models of nominal price rigidity. The most well-known example of this theory is the New Keynesian Phillips Curve (NKPC).
In this article, I evaluate how well a structural NKPC can account for the changing nature of inflation in the United States from the 1950s to today. First, I document that changes in average inflation have been associated with changes in the dynamics of inflation as measured by inflation persistence and the co-movement of inflation with measures of real activity that the NKPC predicts are relevant for inflation. Then I argue that the NKPC with fixed structural parameters cannot account for these changes in the inflation process. I conclude that the NKPC does not provide a complete structural interpretation of the Phillips curve. This is troublesome since the changed inflation dynamics are related to changes in average inflation, which are presumably driven by systematic monetary policy. But if the NKPC is not invariant to systematic changes of monetary policy, then its use for monetary policy is rather limited.
In models with nominal rigidities, sticky-price models for short, monopolistically competitive firms set their prices as markups over their marginal cost. Since these firms are limited in their ability to adjust their nominal prices, future inflation tends to induce undesired changes in their relative prices. When firms have the opportunity to adjust their prices they will, therefore, set their prices contingent on averages of expected future marginal cost and inflation. The implied relationship between inflation and economic activity is potentially quite complicated, but for a class of models one can show that to a first-order approximation current inflation is a function of current marginal cost and expected future inflation, the so-called NKPC. The coefficients in this NKPC are interpreted as structural in the sense that they are likely to be independent of monetary policy.
In the U.S. economy, inflation tends to be very persistent, in particular, it tends to be at least as persistent as is marginal cost. At the same time, inflation is not that strongly correlated with marginal cost. This observation appears to be inconsistent with the standard NKPC since here inflation is essentially driven by marginal cost, and inflation is, at most, as persistent as marginal cost. But if inflation is as persistent as is marginal cost then the model also predicts a strong positive correlation between inflation and marginal cost. One can potentially account for this observation through the use of a hybrid NKPC which makes current inflation not only a function of expected future inflation, but also of past inflation as in standard statistical Phillips curves. With a strong enough backward-looking element, inflation persistence then need not depend on the contributions from marginal cost alone.
Another feature of U.S. inflation is that average inflation has always been positive, and it has varied widely: periods of low inflation, such as the 1950s and 1960s, were followed by a period of very high inflation in the 1970s, and then low inflation again since the mid-1980s. Cogley and Sbordone (2005, 2006) point out that the NKPC relates inflation and marginal cost defined in terms of their deviations from their respective trends. In particular, the standard NKPC defines trend inflation to be zero. Given the variations in average U.S. inflation, Cogley and Sbordone (2005, 2006) then argue that accounting for variations in trend inflation will make deviations of inflation from trend less persistent. Furthermore, as Ascari (2004) shows, the first-order approximation of the NKPC needs to be modified when the approximation is taken at a positive inflation rate.
I build on the insight of Cogley and Sbordone (2005, 2006) and study the implications of a time-varying trend inflation rate for the autocorrelation and cross-correlation structure of inflation and marginal cost. In this I extend the work of Fuhrer (2006) who argues that the hybrid NKPC can account for inflations's autocorrelation structure only through a substantial backward-looking element. In this article, I argue that a hybrid NKPC, modified for changes in trend inflation, cannot account for changes in the autocorrelation and cross-correlation structure of inflation and marginal cost in the United States.
The article is organized as follows. Section 1 describes the dynamic properties of inflation and marginal cost in the baseline NKPC and the U.S. economy. Section 2 describes and calibrates the hybrid NKPC, and it compares the autocorrelation and cross-correlation structure of inflation and marginal cost in the model with that of the 1955-2005 U.S. economy. Section 3 characterizes the inflation dynamics in the NKPC modified to account for nonzero trend inflation. I then study if the changes of inflation dynamics, associated with changes in trend inflation comparable to the transition into and out of the high inflation period of the 1970s, are consistent with the changing nature of inflation dynamics in the U.S. economy for that period.
1. INFLATION AND MARGINAL COST IN THE NKPC
Inflation in the baseline NKPC is determined by expectations about future inflation and a measure of current economic activity. There are two fundamental differences between the NKPC and more traditional specifications of the Phillips curve. First, traditional Phillips curves are backward looking and relate current inflation to lagged inflation rates. Second, the measure of real activity in the NKPC is based on a measure of how costly it is to produce goods, whereas traditional Phillips curves use the unemployment rate as a measure of real activity. More formally, the baseline NKPC is
[^.[pi].sub.t] = [[kappa].sub.0][^.s.sub.t] + [beta][E.sub.t] [[^.[pi].sub.t+1]] + [u.sub.t], (1)
where [^.[pi].sub.t], denotes the inflation rate, [^.s.sub.t] denotes real marginal cost, [E.sub.t][^.[pi].sub.t+1] denotes the expected value of next period's inflation rate conditional on current information, [u.sub.t] is a shock to the NKPC, [beta] is a discount factor, 0 < [beta] < 1, and [[kappa].sub.0] is a function of structural parameters described below. The baseline NKPC is derived as the local approximation of equilibrium relationships for a particular model of the economy, the Calvo (1983) model of price adjustment.
For the Calvo model one assumes that all firms are essentially identical, that is, they face the same demand curves and cost functions. The firms are monopolistically competitive price setters, but can adjust their nominal prices only infrequently. In particular, whether a firm can adjust its price is random, and the probability of price adjustment is constant. Random price adjustment introduces ex post heterogeneity among firms, since with nonzero inflation a firm's relative price will depend on how long ago the firm last adjusted its price. …
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