Academic journal article Economic Inquiry

Estimating a New Keynesian Phillips Curve with a Corrected Measure of Real Marginal Cost: Evidence in Japan

Academic journal article Economic Inquiry

Estimating a New Keynesian Phillips Curve with a Corrected Measure of Real Marginal Cost: Evidence in Japan

Article excerpt

I. INTRODUCTION

The New Keynesian Phillips curve (NKPC), which was developed most notably by Rotemberg (1982a) and Calvo (1983), holds a central place in the recent monetary economics. Yet, despite its theoretical importance, empirical studies do not necessarily assess the NKPC as a good description of actual inflation dynamics. In relatively earlier studies, such as Gali and Gertler (1999), Gali, Gertler, and Lopez-Salido (2001), and Sbordone (2002), there has been some consensus that the fit of the NKPC in the United States or the Euro area is good if we use labor share (real unit labor cost) as the proxy for real marginal cost (RMC). However, the more recent studies by Rudd and Whelan (2005a, 2005b, 2006, 2007) show that there is scarce evidence on the correlation between the inflation rate and the discounted sum of future labor shares as for the U.S. economy. They also show that the observed good performance of the "hybrid" NKPC, which introduces lagged inflation term as an additional explanatory variable, is just brought by lagged inflation, not by the discounted sum of future labor shares. (1) These results imply that the fit of the NKPC is actually poor and that a backward-looking component plays a more important role in explaining the actual inflation dynamics.

Nevertheless, we can further consider the possibility that the fit of the NKPC is poor only because labor share is not a good proxy for RMC. Rotemberg and Woodford (1999) explain that "while labor share (or equivalently, the ratio of price to unit labor cost) is a familiar and easily interpretable statistic, it represents a valid measure of markup variations only under relatively special assumptions" (1064). They show that some corrections to labor share would be required to obtain a more realistic measure of RMC, and these corrections would imply that RMC is more procyclical than labor share. In the context of the NKPC, Wolman (1999) suggests that "continued progress in empirical evaluation of sticky-price models will require intensive study of the factors determining real marginal cost. With more refined estimates of real marginal cost, it may be possible to reconcile a plausible sticky-price specification with data on inflation (45). (2)

To apply these ideas, we estimate the NKPC for Japan's economy, focusing on the measurement of RMC. To obtain a better proxy for RMC, we correct labor share by taking account of two kinds of labor market frictions: (1) labor adjustment costs and (2) real wage rigidity. This can be done because we have a direct measure on the degree of labor market frictions in Japan. As an extension, we also incorporate materials prices in the calculation of RMC, following Batini, Jackson, and Nickell (2005). (3)

Our exercise shows that the fit of the NKPC is poor in Japan if we naively use labor share as the proxy for RMC. This result is just the same as the United States or the Euro area. However, the consideration of the two kinds of labor market frictions greatly improves the fit of Japan's NKPC. Furthermore, if we incorporate materials prices, the fit of the NKPC is further improved. We find that the inclusion of lagged inflation term into the NKPC does not improve the fit of the NKPC at all. This result indicates that the conventional backward-looking component is no more needed to explain Japan's inflation dynamics if we use a corrected measure of RMC.

Our study contributes to the literature in three respects. First, we present a method to obtain a better proxy of RMC by correcting labor share with the information of labor market frictions. Second, we give an evidence that the fit of the NKPC can be underestimated due to the problem that labor share does not correctly capture the movement of RMC. Third, we show that the role of a backward-looking component can be overestimated due to the discrepancy between labor share and RMC. These findings imply that the argument of Rotemberg and Woodford (1999) is relevant for evaluating the performance of the NKPC, as is predicted by Wolman (1999). …

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