New Versus Traditional Phillips Curves As Well As The Peachy Recession

For economists

One of the questions I similar quest students is whether inflation next the Great Recession has tended to favour the New Keynesian (NK) Phillips crimp or its to a greater extent than traditional counterpart (TK). I similar it because it allows me to depict a squeamish diagram, together with too because it shows students how hard it is to discriminate betwixt theories inwards macro.

So showtime the theory. The 2 competing models are

• NK: Inflation at t = expected inflation at t+1 together amongst a term inwards the output gap
• TK: inflation at t = inflation at t-1 together amongst a term inwards the output gap

I’m ignoring discounting inwards the NK Phillips crimp for simplicity. Assume expectations almost inflation are rational, together with suppose the economic scheme is striking yesteryear an unexpected recession of known size together with duration. The 2 models predict the following:

With the traditional model, inflation gradually falls every bit the recession continues, together with ane time it comes to an end, inflation remains lower. In the New Keynesian model, assuming that the inflation target is credible, inflation jumps downward when the unexpected recession occurs, together with thence inflation gradually rises towards its target every bit the recession progresses. (We assume hither that the output gap is constant piece the recession lasts, ane time to a greater extent than for simplicity.) For the NK model, it is critical inwards drawing this diagram that the extent of the recession is known – to a greater extent than on this below. The patterns implied yesteryear the 2 models are distinct, together with this deviation is probable to persist fifty-fifty if each crimp becomes flatter every bit nosotros approach nix inflation because of nominal wage rigidities.

To run across what has genuinely happened, run across this squeamish post from Gavyn Davies. The immediate aftermath of the recession looked to a greater extent than similar the NK model: a sudden autumn followed yesteryear a gradual rise. Furthermore I would fence that – ane time the recession striking – most people expected it to live large together with persistent, thence my diagram is non totally unrealistic. But if nosotros aspect at what has been happening inwards the concluding 2 years, it looks much to a greater extent than similar the TK model, amongst inflation gradually falling below target.

That is in all likelihood every bit far every bit nosotros should operate without doing or thence econometrics, together with too taking line organisation human relationship of or thence of the complexities discussed here. We could in all likelihood teach whatever designing to check the NK model yesteryear imagining a suitable sequence of expectations errors. In improver if nosotros are looking at consumer cost inflation nosotros should line organisation human relationship for commodity cost changes, which neither model does. (If nosotros aspect at gross domestic product deflators, you lot could say a floor where agents were initially expecting a recession lasting 3 or 4 years, together with convey been surprised that the recession has persisted e'er since.) That is why or thence proper econometrics is required, preferably looking at both cost together with wage inflation together with expectations data. (If such studies convey been done, delight allow me know.)

However maybe I tin propose 2 possible conclusions that such studies could examination to a greater extent than rigorously. First, the traditional Phillips curve, where expectations are implicitly naive together with backward looking, does non aspect similar a promising footing for explaining inflation next the recession. Either the New Keynesian model, or or thence combination of the 2 models, looks to a greater extent than similar providing an adequate foundation for a reasonable explanation. Second, an explanation based on the NK model that treats the size together with extent of the recession (whatever that turns out to be) every bit ane initially unexpected but thence completely anticipated stupor is too going to fighting to check the data.