Abstract
ABSTRACTIn this paper, the empirical analysis finds that the dynamics of inflation and unemployment can be described by a Phillips curve when allowing for a positive co-movement between trend-adjusted productivity and unemployment. This suggests that improvements in productivity have been achieved by laying off the least productive part of the labor force. Furthermore, the natural rate of unemployment is a function of the long-term interest rate, indicating that monetary policy is not completely neutral in the long run. This result rejects the natural rate hypothesis and, at the same time, provides empirical support for the structural slump theory in a world of imperfect knowledge. The recent theory of imperfect knowledge economics (IKE) seems to address the problem that many economic models lack: persistence in the observed data. By combining IKE and the structural slumps theory it is possible to obtain predictions that are theoretically and empirically consistent.
Highlights
Since Phillips (1958) observed a negative relationship between wage inflation and the unemployment rate, known as the Phillips curve, numerous studies have analyzed this relationship empirically and theoretically
There is a natural rate of unemployment acting as a long-run attractor for the unemployment rate, and, in the long run, unemployment is independent of the rate of inflation
The results in this paper suggest that there is a long-run trade-off between inflation and unemployment when allowing for a positive co-movement between trend-adjusted productivity and unemployment
Summary
Since Phillips (1958) observed a negative relationship between wage inflation and the unemployment rate, known as the Phillips curve, numerous studies have analyzed this relationship empirically and theoretically. The results in this paper suggest that there is a long-run trade-off between inflation and unemployment when allowing for a positive co-movement between trend-adjusted productivity and unemployment This is consistent with empirical evidence that finds a long-run trade-off between inflation and unemployment in the United States (Fair, 2000; Karanassou, Sala, & Snower, 2005; King & Watson, 1994), Spain (Dolado, López-Salido, & Juan, 2000), Finland (Juselius & Juselius, 2012), and the European Union (Karanassou et al, 2005). The fact that the interest rate co-moves with the natural rate of unemployment in the long run challenges the classical dichotomy that nominal variables do not affect real variables and that inflation and unemployment can be separately analyzed if there is no trade-off between them in the long run This result, is in consonance with Blanchard (2003), which implicitly states that monetary policy may have real effects on the economy:. If we accept the fact that monetary policy can affect the real interest rate for a decade and perhaps more, we must accept, as a matter of logic, that it can affect activity, be it output or unemployment, for a roughly equal time (Blanchard, 2003, p. 3)
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