Investigating the Structural Stability of the Phillips Curve Relationship
48 Pages Posted: 12 Oct 2008
Date Written: May 1, 2008
The reduced-form correlation between inflation and measures of real activity has changed substantially for the main developed economies over the post-WWII period. In this paper we attempt to describe the observed inflation dynamics in the United Kingdom, the United States and the euro area with a sequence of New Keynesian Phillips Curve (NKPC) equations that are log-linearised around different, non-zero, steady-state inflation levels. In doing this, we follow a two-step estimation strategy. First, we model the time variation in the relationship between inflation and a real cost-based measure of activity through a Markov-switching vector autoregressive model. We then impose the cross-equation restrictions of a Calvo pricing-based NKPC under non-zero steady-state inflation and estimate the structural parameters by minimising for each inflation state the distance between the restricted and unrestricted vector autoregressive parameters. The structural estimation results indicate that for all the economies there is evidence for a structurally invariant NKPC, albeit with a significant backward-looking component.
Keywords: New Keynesian Phillips Curve, trend inflation, Markov-switching VAR, minimum distance estimation
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