New Keynesian Phillips Curve with time-varying parameters

Abstract

I generalize the New Keynesian Phillips Curve model of Gali and Gertler (J Monet Econ 44:195–222, 1999) to allow for time-varying parameters. The parameter of interest measures the trade-off between inflation and real economic activity, and it is particularly a nonlinear function of three underlying structural parameters: the discount factor, the degree of price rigidity and the strength of backward-looking behavior or information diffusion. The empirical results show that the estimated parameter of output-inflation trade-off is time varying and is larger in high inflation periods. Specifically, the time-variation of the trade-off between inflation and economic activity stems from the degree of price rigidity, which is negatively correlated with inflation. Moreover, the forward-looking price-setting behavior plays a dominant role in explaining inflation dynamics for most part of the sample period.