Optimal Inflation and the Identification of the Phillips Curve

29 Pages Posted: 11 Jun 2018

See all articles by Michael McLeay

Michael McLeay

Bank of England - Monetary Assessment and Strategy Division

Silvana Tenreyro

London School of Economics (LSE)

Date Written: June 2018

Abstract

This paper explains why inflation follows a seemingly exogenous statistical process, unrelated to the output gap. In other words, it explains why it is difficult to empirically identify a Phillips curve. We show why this result need not imply that the Phillips curve does not hold -- on the contrary, our conceptual framework is built under the assumption that the Phillips curve always holds. The reason is simple: if monetary policy is set with the goal of minimising welfare losses (measured as the sum of deviations of inflation from its target and output from its potential), subject to a Phillips curve, a central bank will seek to increase inflation when output is below potential. This targeting rule will impart a negative correlation between inflation and the output gap, blurring the identification of the (positively sloped) Phillips curve.

Keywords: identification, Inflation targeting, Phillips curve

Suggested Citation

McLeay, Michael and Tenreyro, Silvana, Optimal Inflation and the Identification of the Phillips Curve (June 2018). CEPR Discussion Paper No. DP12981. Available at SSRN: https://ssrn.com/abstract=3193984

Michael McLeay (Contact Author)

Bank of England - Monetary Assessment and Strategy Division ( email )

Threadneedle Street
London EC2R 8AH
United Kingdom

Silvana Tenreyro

London School of Economics (LSE) ( email )

Houghton Street
London WC2A 2AE
United Kingdom

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