The Lucas hypothesis on the Phillips Curve: Further international evidence

Abstract

This paper is a further attempt to test the ‘Lucas Hypothesis on the Phillips Curve’ by making cross country comparisons. That hypothesis posits that nominal shocks affect real aggregates only if individuals mistake them for what they are not — movements in real variables. The existence of a trade-off between output and inflation is conditional on economic agents misinterpreting the price movements they observe. Countries with widely fluctuating exogenous shocks will have a more vertical Phillips Curve as their inhabitants sharpen their instrumental to differentiate between real and nominal shocks. Hence cross country comparisons provide fertile grounds to test this hypothesis; if it holds true, we should find a positive correlation between Phillips Curve slopes and the standard deviations of the exogenous shocks. The evidence presented here confirms Lucas's findings.