Has The Slap-Up Recession Killed The Traditional Phillips Curve?

Before the New Classical revolution at that spot was the Friedman/Phelps Phillips Curve (FPPC), which said that electrical current inflation depended on some stair out of the output/unemployment gap too the expected value of current inflation (with a unit of measurement coefficient). Expectations of inflation were modelled every bit some business office of past times inflation (e.g. adaptive expectations) - at its simplest precisely 1 lag inwards inflation. Therefore inwards exercise inflation depended on lagged inflation too the output gap.

After the New Classical revolution came the New Keynesian Phillips Curve (NKPC), which had electrical current inflation depending on some stair out of the output/unemployment gap too the expected value of inflation inwards the next period. If this was combined amongst adaptive expectations, it would amount to much the same thing every bit the FPPC, but instead it was usually combined amongst rational expectations, where agents made their best guess at what inflation would live adjacent menses using all relevant information. This would include past times inflation, but it would include other things every bit well, similar prospects for output too whatsoever official inflation target.

Which meliorate describes the data? The smashing attraction of the FPPC is that it tin dismiss depict stagflation. We direct maintain a boom, which piece it lasts steadily raises inflation. When the boom comes to an end, inflation stabilises, but at a much higher score than it began. So policy has to engineer a recession to teach inflation dorsum downwards again: a menses inwards which inwards a higher house average unemployment is accompanied past times inwards a higher house average inflation, which nosotros telephone telephone stagflation. If over this menses nosotros had had credible independent key banks setting inflation targets, the NKPC would non give us stagflation: when the boom came to an end, inflation would render to target. (For to a greater extent than explanation, come across this calls the Neo-paleo-Keynesian Phillips curve.]

Here is this plot for 4 countries, using OECD estimates for the output gap on the horizontal axis, consumer cost inflation less 2% on the vertical axis, too OECD forecasts for 2014 too 2015. I’ve chosen these countries precisely because inwards nearly of Europe nosotros had a double dip recession, which is a to a greater extent than complicated experiment. If yous produce non similar the catch of including forecasts, precisely ignore the concluding 2 points for each country.

The lines signal North East, non South East. This gives to a greater extent than back upward to the rational expectations NKPC than the adaptive expectations FPPC. To accept precisely 1 example, U.S. of A. of America inflation inwards 2013 is higher than it was inwards 2009, which is consistent amongst the NKPC. The traditional FPPC, on the other hand, would advise that after a string of negative output gaps, U.S. of A. of America inflation should live a lot lower inwards 2013 than it was inwards 2009.

OK, straightaway the caveats. Commodity prices volition direct maintain an of import influence on the CPI, too these are non percentage of either elementary Phillips bend story. They may assist explicate the blip inwards inflation to a greater extent than or less 2011 inwards some countries, but they every bit good helped depress inflation inwards 2009. Exchange charge per unit of measurement changes volition every bit good matter. The elementary Phillips bend every bit good takes no problem concern human relationship of non-linearity caused past times a reluctance to cutting nominal wages. And of course of study estimates of the output gap may live wrong.

In the instance of Japan, nosotros every bit good had a recent growth inwards the inflation target. This may explicate the forecast upward shift inwards inflation inwards 2014/5. If it does, that is clear testify inwards favour of rational rather than adaptive expectations. 

All these caveats signal to the postulate to produce to a greater extent than empirical analysis. Nevertheless nosotros tin dismiss come across why some to a greater extent than elaborate studies (like this for the US) tin dismiss claim that recent inflation sense is consistent amongst the NKPC. It seems much to a greater extent than hard to foursquare this sense amongst the traditional adaptive expectations Phillips curve. As I suggested at the beginning, this is actually a essay out of whether rational expectations is a meliorate description of reality than adaptive expectations. But I post.) The problem is nosotros did non direct maintain inflation targeting during this period, then it is hard to say whether stagflation is testify against the NKPC. (As an representative of this ambiguity, come across this survey of the empirical testify past times Nason too Smith. This enabled Robert Gordon to live quite supportive of the FPPC inwards 2009.)

The Great Recession could furnish a much meliorate test. In some countries output brutal sharply inwards 2009, but has since seen a tedious but steady recovery, such that the output gap today is less than it was inwards 2009. With the FPPC, inflation should direct maintain been steadily falling over this period, reaching its lowest score today. So if nosotros plotted the output gap (x axis) too inflation (y axis) together, nosotros should come across a describe pointing South East. With the NKPC, nosotros tin dismiss consider 2 polar cases. In the first, agents fully anticipate that the recovery volition live slow, then nosotros volition teach a sudden immediate autumn inwards inflation, but later on inflation volition ascent towards the target. That volition give us a describe pointing North East. In the second, agents run along thinking inflation volition render to target adjacent year. That every bit good gives us a describe pointing North East, but it is flatter. [Postscript - I should direct maintain added that this concluding gives us what Krugman calls the Neo-paleo-Keynesian Phillips curve.]

Here is this plot for 4 countries, using OECD estimates for the output gap on the horizontal axis, consumer cost inflation less 2% on the vertical axis, too OECD forecasts for 2014 too 2015. I’ve chosen these countries precisely because inwards nearly of Europe nosotros had a double dip recession, which is a to a greater extent than complicated experiment. If yous produce non similar the catch of including forecasts, precisely ignore the concluding 2 points for each country.

The lines signal North East, non South East. This gives to a greater extent than back upward to the rational expectations NKPC than the adaptive expectations FPPC. To accept precisely 1 example, U.S. of A. of America inflation inwards 2013 is higher than it was inwards 2009, which is consistent amongst the NKPC. The traditional FPPC, on the other hand, would advise that after a string of negative output gaps, U.S. of A. of America inflation should live a lot lower inwards 2013 than it was inwards 2009.

OK, straightaway the caveats. Commodity prices volition direct maintain an of import influence on the CPI, too these are non percentage of either elementary Phillips bend story. They may assist explicate the blip inwards inflation to a greater extent than or less 2011 inwards some countries, but they every bit good helped depress inflation inwards 2009. Exchange charge per unit of measurement changes volition every bit good matter. The elementary Phillips bend every bit good takes no problem concern human relationship of non-linearity caused past times a reluctance to cutting nominal wages. And of course of study estimates of the output gap may live wrong.

In the instance of Japan, nosotros every bit good had a recent growth inwards the inflation target. This may explicate the forecast upward shift inwards inflation inwards 2014/5. If it does, that is clear testify inwards favour of rational rather than adaptive expectations. 

All these caveats signal to the postulate to produce to a greater extent than empirical analysis. Nevertheless nosotros tin dismiss come across why some to a greater extent than elaborate studies (like this for the US) tin dismiss claim that recent inflation sense is consistent amongst the NKPC. It seems much to a greater extent than hard to foursquare this sense amongst the traditional adaptive expectations Phillips curve. As I suggested at the beginning, this is actually a essay out of whether rational expectations is a meliorate description of reality than adaptive expectations. But I know the determination I clit from the information volition upset some people, then I human face forrad to a to a greater extent than sophisticated empirical analysis showing why I’m wrong.