Magazine article Business Review (Federal Reserve Bank of Philadelphia)

Inflation Dynamics and the New Keynesian Phillips Curve

Magazine article Business Review (Federal Reserve Bank of Philadelphia)

Inflation Dynamics and the New Keynesian Phillips Curve

Article excerpt

Policymakers, economists, and the public generally agree that low and stable inflation is beneficial to the economy. Low and stable inflation makes it easier for households to plan their savings and investments and for firms to make production and investment decisions. It also helps to promote equity across members of society, since low-income households often do not have access to the financial instruments that help guard savings from being eroded by inflation. (1) Also, households and firms often write contracts that are stated in dollar amounts (nominal terms). A worker may, for example, sign a contract to work over the upcoming year for a fixed dollar amount. If inflation turns out to be higher than what was expected at the time the contract was made, the worker may find he is unable to purchase as many goods and services as planned because his inflation-adjusted income is lower than expected. Stable inflation would help mitigate such problems.

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A 1977 amendment to the Federal Reserve Act codified the importance of low and stable inflation as a goal for monetary policymakers. The amendment states that the Fed's mandate is "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." Moderate long-term interest rates require low and stable inflation, on average. But how does the Fed control inflation? It cannot simply dictate that the rate of price increase will be, say, 2 percent. Rather, monetary policymakers use instruments such as a short-term interest rate to guide the economy with the aim of achieving an inflation objective. To help guide their decisions, monetary policymakers benefit from having a reliable theory of how inflation is determined: a theory that relates the setting of their instrument to the unexpected events that hit the economy and consequently to the rate of inflation and to other economic variables of interest. With such a model in hand, policymakers can make informed decisions about the likely course of inflation and how to set an instrument such as the federal funds rate to achieve their inflation objectives.

In this article, we will examine a prominent theory of how inflation is determined, as articulated in what is called the New Keynesian Phillips curve. The theory ties current inflation to expected future inflation, a measure of firms' cost of production, and shocks that hit the economy. When embedded in a larger model of the economy that determines how inflation expectations are formed, the theory gives guidance to policymakers on how to meet their inflation goals. Consequently, we will also investigate some of the implications of the theory for the conduct of monetary policy.

A LITTLE HISTORY: INFLATION AND EMPLOYMENT

There is a long and storied history in macroeconomics about the relationship between inflation and real economic activity. In 1958, William Phillips wrote a paper on the empirical relationship between wage inflation and unemployment in the U.K. over the period 1861-1957. Phillips observed that when wage inflation was high, the unemployment rate tended to be low, and vice versa. This inverse empirical relationship seemed to suggest that there might be a stable, permanent tradeoff between wage inflation, or price-level inflation more generally, and the unemployment rate. If so, policymakers could stimulate the economy and lower the unemployment rate at the expense of somewhat higher inflation. Indeed, for the U.S. economy, there appeared to be a stable tradeoff between inflation and the unemployment rate in the 1960s (Figure 1). (2)

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Unfortunately, the Phillips curve turned out to be not as stable as was first believed. The 1970s were a decade during which the economy experienced both high inflation and high unemployment rates, a development that came to be known as stagflation. Indeed, examining the entire span of data from the 1960s to the present, it is difficult to discern a tradeoff between inflation and unemployment. …

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