Academic journal article Economic Commentary (Cleveland)

The Flattening of the Phillips Curve: Policy Implications Depend on the Cause

Academic journal article Economic Commentary (Cleveland)

The Flattening of the Phillips Curve: Policy Implications Depend on the Cause

Article excerpt

(ProQuest: ... denotes formulae omitted.)

The recent behavior of inflation in the United States and some other advanced economies has been the subject of considerable analysis and commentary. Many observers have been surprised that inflation hasn't risen more than it has in the past few years as the economy has continued to strengthen. According to the historical relationship known as the Phillips curve, strengthening of the economy is commonly associated with increasing inflation. With inflation having only modestly picked up in the past few years as the economy has become more robust, many believe the Phillips curve relationship has weakened. This seemingly reduced sensitivity of inflation to economic conditions is commonly referred to as a flattening of the Phillips curve.

The recent experience that suggests a flattening of the Phillips curve has been corroborated by some research.1 What is less clear is what may have been behind the flattening. The Phillips curve relationship depends on many economic factors, and the flattening may have been caused by a change in any of these factors. One possibility is that the flattening may have been caused by a change in the way monetary policy responds to inflation and economic conditions. Another possibility is that something else fundamental has changed in the economy, for instance the openness of the economy to foreign trade or the way firms set wages and prices.2

What a flatter Phillips curve might mean for the appropriate conduct of monetary policy depends on what has caused the flattening. In this article, I illustrate this point with the help of a modern model of the economy. I first use the model to show that a flatter Phillips curve could be caused by a structural change unrelated to policy or a change in the behavior of monetary policy. I then consider one possible adjustment to the conduct of monetary policy following the flattening and I show that whether the adjustment is appropriate depends on what has caused the flattening.

The Model

To understand possible sources of the flattening of the Phillips curve and its implications for monetary policy, I use a model that is meant to capture the business cycle behavior of the economy. The model-commonly referred to as the New Keynesian model-represents the behavior of households, firms, and monetary policy.3 Households choose work hours and consumption levels to maximize current and expected future utility. Firms produce goods and set prices to maximize profits. The central bank (the Federal Reserve in the United States) sets the short-term interest rate to try to stabilize economic activity and inflation. A key feature of this modern model is that the agents in the model are forward-looking. Expectations of future output, inflation, and interest rates play key roles in determining current economic outcomes.

One important assumption of the model is that firms are slow to adjust prices, an assumption referred to as sticky prices. This assumption is meant to replicate in a stylized way that the prices of goods and services are slow to change in the real world. The model assumes that, in each period, a random fraction of firms, 0, cannot change the prices of the goods they sell. With this assumption, the parameter 0 controls how sticky the price level is in the economy: the higher 0, the stickier the price level.

The main macroeconomic variables are output, inflation, and the interest rate. Let yt, п , and it denote, respectively, the logarithm of output (or log-output), the inflation rate, and the nominal interest rate. The goal of the model is to characterize the dynamics of these macroeconomic variables given the dynamics of three kinds of macroeconomic shocks that hit the economy (a technology shock, a demand shock, and a monetary policy shock).

The model makes use of a few key concepts. One is known as the steady state. The steady-state value of a variable is the one that will prevail in the long run, after business cycle influences have died out. …

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