A Bounded Model of Time Variation in Trend Inflation, NAIRU and the Phillips Curve

35 Pages Posted: 23 Jan 2014 Last revised: 14 Oct 2014

See all articles by Joshua C. C. Chan

Joshua C. C. Chan

University of Technology Sydney (UTS) - UTS Business School; Purdue University

Gary Koop

University of Strathclyde, Glasgow - Strathclyde Business School - Department of Economics

Simon Potter

Federal Reserve Bank of New York

Date Written: January 1, 2014

Abstract

In this paper, we develop a bivariate unobserved components model for inflation and unemployment. The unobserved components are trend inflation and the non-accelerating inflation rate of unemployment (NAIRU). Our model also incorporates a time-varying Phillips curve and time-varying inflation persistence. What sets this paper apart from the existing literature is that we do not use unbounded random walks for the unobserved components, but rather use bounded random walks. For instance, trend inflation is assumed to evolve within bounds. Our empirical work shows the importance of bounding. We find that our bounded bivariate model forecasts better than many alternatives, including a version of our model with unbounded unobserved components. Our model also yields sensible estimates of trend inflation, NAIRU, inflation persistence and the slope of the Phillips curve.

Keywords: trend inflation, non-linear state space model, natural rate of unemployment, inflation targeting, Bayesian

Suggested Citation

Chan, Joshua C. C. and Koop, Gary and Potter, Simon, A Bounded Model of Time Variation in Trend Inflation, NAIRU and the Phillips Curve (January 1, 2014). CAMA Working Paper No. 10/2014. Available at SSRN: https://ssrn.com/abstract=2382980 or http://dx.doi.org/10.2139/ssrn.2382980

Joshua C. C. Chan (Contact Author)

University of Technology Sydney (UTS) - UTS Business School ( email )

Sydney
Australia

Purdue University

West Lafayette, IN 47907-1310
United States

Gary Koop

University of Strathclyde, Glasgow - Strathclyde Business School - Department of Economics ( email )

100 Cathedral Street
Glasgow G4 0LN
United Kingdom

Simon Potter

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States
212-720-6309 (Phone)
212-720-1844 (Fax)

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