The Output Gap–Inflation Trade-off and the Policy Ineffectiveness

Abstract

To what extent is the output gap–inflation trade-off impacted by the role of the 6 per cent inflation threshold? In addition, do inflation regimes impact the effect of nominal demand shocks on the output gap–inflation trade-off? Evidence in this chapter shows the existence of the output gap–inflation trade-off. The results show that real output rises more in a low inflation regimes than in a high inflation regimes. In addition, evidence shows that a higher degree of the output gap–inflation trade-off movements occurs in low inflation regimes. This evidence suggests that a positive nominal demand policy shock that affects nominal demand will have a bigger effect on real output in a low inflation regime than in a high inflation regime. Evidence showing that the output gap–inflation trade-off is low in high inflation regimes implies that nominal demand shocks are passed through more to consumer and nominal wage inflation pressures than to real output. The slope of the Philips curve is steeper in high inflation regimes than in low inflation regimes. The data supports the new Keynesian hypothesis which implies that demand policy interventions are less effective in countries with high trend inflation and where prices are less rigid.