Inflation in the G7: Mind the Gap(s)?

Abstract

We investigate the importance of trend and the real-activity gap for explaining observed variation in G7 countries since 1960. Our results are based on a bivariate unobserved-components model of and unemployment in which is decomposed into a stochastic trend and transitory component. As in recent implementations of the New Keynesian Phillips Curve, it is the transitory component of inflation, or inflation that is driven by the real-activity gap, which we measure as the deviation of unemployment from its natural rate. Even when allowing for changes in the contributions of trend and the gap, we find that both are important determinants of variation at business cycle horizons for all G7 countries throughout much of the past 50 years. Also, the real-activity gap explains a large fraction of the variation in the gap for each country, both historically and in recent years. Taken together, the results suggest the New Keynesian Phillips Curve, once augmented to include trend inflation, is an empirically relevant model for the G7 countries. We also provide new estimates of trend for the G7 that incorporate information in the real-activity gap for identification and, through formal model comparisons, new statistical evidence regarding structural breaks in the variability of trend and the gap.