Working Paper: CEPR ID: DP12981
Authors: Michael McLeay; Silvana Tenreyro
Abstract: This paper explains why inflation follows a seemingly exogenous statistical process, unrelated to the output gap. In other words, it explains why it is difficult to empirically identify a Phillips curve. We show why this result need not imply that the Phillips curve does not hold – on the contrary, our conceptual framework is built under the assumption that the Phillips curve always holds. The reason is simple: if monetary policy is set with the goal of minimising welfare losses (measured as the sum of deviations of inflation from its target and output from its potential), subject to a Phillips curve, a central bank will seek to increase inflation when output is below potential. This targeting rule will impart a negative correlation between inflation and the output gap, blurring the identification of the (positively sloped) Phillips curve.
Keywords: Phillips curve; Inflation targeting; Identification
JEL Codes: No JEL codes provided
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| inflation (E31) | output gap (E23) |
| output gap (E23) | inflation (E31) |
| cost-push shocks (E31) | inflation (E31) |
| targeting rule shocks (D80) | inflation (E31) |
| targeting rule shocks (D80) | output gap (E23) |
| optimal monetary policy (E63) | inflation (E31) |
| optimal monetary policy (E63) | output gap (E23) |