Explaining Apparent Changes in the Phillips Curve: The Great Moderation and Monetary Policy

By Carlstrom, Charles T.; Fuerst, Timothy S. | Economic Commentary (Cleveland), February 2008 | Go to article overview

Explaining Apparent Changes in the Phillips Curve: The Great Moderation and Monetary Policy


Carlstrom, Charles T., Fuerst, Timothy S., Economic Commentary (Cleveland)


Observations that the Phillips curve may be deviating from historical norms are important to policymakers because deviations would imply that more or less output has to be sacrificed to achieve a permanent reduction in long-term inflation. But we argue that recent economic shocks and a shift in the Fed's response to inflation may be leading economists to misestimate the curve.

Ever since it was introduced five decades ago, many monetary policymakers have turned to the Phillips curve for the information and predictions it provides about the behavior of inflation. The curve, a standard part of many macroeconomic models, attempts to capture the relationship between current inflation and past inflation, expected inflation, and the output gap (the difference between the economy's actual and potential output). Some assumptions are usually made when estimating the curve, one being that current inflation is a function of past inflation (because it is a good proxy for inflation expectations) and the current level of the output gap.

Recent calculations of the curve indicate that two aspects of it appear to be deviating from historical norms. The degree to which current inflation depends on past inflation, referred to as inflation persistence, has declined, as has the slope of the curve, which expresses the degree to which current inflation depends on the output gap.

Both changes could have important policymaking implications because they imply that more output has to be sacrificed in order to achieve a permanent reduction in inflation. Each of the declines increases what is known as the curve's implied sacrifice ratio, which is defined as the cumulative change in the output gap associated with a permanent change in long-term inflation.

But estimating the Phillips curve is tricky. Besides having to proxy for factors that aren't observable, like expected inflation, economists must deal with the fact that the curve can be hit by "markup shocks," which complicate the curve's estimation because they cause inflation and the output gap to move in ways that are opposite to what the curve would ordinarily predict. To further complicate the curve's interpretation, other recent economic developments are probably accentuating the effects of these shocks. These developments include the declining volatility of potential output and a shift in the central bank's operating procedure, which has made it more of an inflation-targeter. We argue that it is quite probable that economists have been misestimating the Phillips curve recently and that the underlying Phillips curve, and thus the sacrifice ratio, have not really changed significantly.

Changes in the Inflation Process

Figures 1 and 2 show why many think that the inflation process represented by the Phillips curve has fundamentally changed. These figures show estimates of inflation persistence and the slope of the Phillips curve since 1970 in rolling ten-year windows. We have corrected the estimates for changes in long-term inflation that may have occurred during this time period (For more detail see the Recommended Reading.

Around 1990 there was a rather dramatic decline in inflation persistence, from a value of roughly 0.7 to a value of 0 (or even negative!) within the matter of a few years. A few years later, the slope of the Phillips curve flattened. Our corrected estimation of the curve suggests that the underlying relationships haven't changed as much as people fear: the decline in the slope of the curve is not historically unusual. However, the magnitude of the decline in inflation persistence is.

Still, it is not clear that estimations of the Phillips curve tell us unequivocally that either inflation persistence or the relationship between inflation and the output gap has declined. These estimations can be distorted by shocks to the curve itself.

Phillips Curve Basics

The kind of shock that complicates the estimation of the Phillips curve is a mark-up shock. …

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