Abstract
Confidence in the Phillips Curve (PC) as predictor of inflation developments along the business cycle has been shaken by recent “inflation puzzles” in advanced countries, such as the “missing disinflation” in the aftermath of the Great Recession and the “missing inflation” in the years of recovery, to which the Euro-Zone “excess deflation” during the post-crisis depression may be added. This paper proposes a newly specified Phillips Curve model, in which expected inflation, instead of being treated as an exogenous explanatory variable of actual inflation, is endogenized. The idea is simply that if the PC is used to foresee inflation, then its expectational component should in some way be the result of agents using the PC itself. As a consequence, the truly independent explanatory variables of inflation turn out to be the output gaps and the related forecast errors by agents, with notable empirical consequences. The model is tested with the Euro-Zone data 1999–2019 showing that it may provide a consistent explanation of the “inflation puzzles” by disentangling the structural component from the expectational effects of the PC.
Highlights
The Great Recession of 2008–2009 represents a watershed for macroeconomics
SE are displayed in parentheses a 1% increase in the forecast error implies a drop of the inflation level 0.22% with ordinary least squares (OLS) estimation, while the reduction decreases to 0.11% in generalized method of moments (GMM) when employing the 1 lag IV
Some so-called “inflation puzzles” have led researchers to wonder whether the Phillips Curve (PC) could still be a valid tool to estimate and foresee the relationship between inflation and the business cycle
Summary
The Great Recession of 2008–2009 represents a watershed for macroeconomics. Kernel relationships broke down, showing fragility of macroeconomic models and their inability to make accurate predictions. Inflation expectations expressed “on the right-hand-side” of the PC are generally treated as independent variables, collected from various available forecast surveys. This practice is not satisfactory for two reasons. The alleged explanatory variables in the PC are co-determined elsewhere in the system, and may not even be independent one of another This is the case of inflation expectations, which are arguably elaborated, in some way and to some extent, according to the evolution of the macroeconomics. The independent explanatory variables of inflation turn out to be the output gaps and the related forecast errors by agents, with notable consequences from an empirical point of view. The last section concludes with a view to new perspectives in terms of empirical research and possible implications regarding monetary and fiscal policies undertaken by public institutions
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