Inflation dynamics: combining measurement with theory.

• Author: Gali, Jordi
• Position: Research Summaries

Among the central issues in macroeconomics is the nature of short-run inflation dynamics. This matter is also one of the most fiercely debated, with few definitive answers available after decades of investigation. At stake, among other things, is the nature of business fluctuations and the appropriate conduct of monetary policy. How a central bank should go about engineering a disinflation, for example, depends critically on the extent to which: 1) there may be a short-run tradeoff between inflation and real activity and 2) expectations of future economic activity affect current price setting behavior. The issue is also highly relevant in the current era of low inflation: how to manage monetary policy to avoid deflation and potentially slipping into a liquidity trap (of the type many observers believe is happening in Japan) is similarly sensitive to how inflation is determined in the short run.

Our research over the past few years has focused on both theoretical and empirical analysis of inflation dynamics. In contrast to much of the important traditional work on the Phillips curve, which was largely empirical in nature, we explicitly employ economic theory to develop an econometric model of inflation. By tying the empirical analysis tightly to theory, we believe we are able to obtain a deeper understanding of what determines inflation in the short run than would be the case from just examining statistical relationships. In addition, by estimating an explicit economic model, we can potentially understand how significant structural changes might affect inflation better than a mainly empirical approach would permit. Examples of significant structural changes include shifts in trend productivity and changes in the monetary policy regime.

The New Keynesian Phillips Curve

Our work builds on the optimization-based approach to modeling short-run inflation dynamics that has been used increasingly in applied work in recent years. This literature, in turn, is an outgrowth of early theoretical work by Fischer (1), Taylor (2), Calvo (3) and others that emphasized staggered nominal wage and price setting by forward looking workers and firms. The modern literature extends this earlier work by casting the price setting decision within an explicit individual optimization problem. Aggregating over individual behavior then leads, typically, to a relationship between inflation in the short run and some measure of overall real activity, in the spirit of the traditional Phillips curve. The explicit use of micro-foundations, of course, places additional structure on the relationship and further leads to some important differences in detail.

A canonical version of this kind of Phillips curve--often referred to as the New Keynesian Phillips Curve (NKPC)--is attributable to Calvo. This approach involves making assumptions that greatly simplify the aggregation of individual price setting, but still retain the feature of non-synchronized multi-period price setting. Because it results in a reasonably parsimonious aggregate relation for inflation, the model has gained widespread attention. It also has generated some controversy; as we discuss below.

There are two basic building blocks to the Calvo variant of the NKPC. The first is an equation that relates current inflation to two factors: the percent deviation of real marginal cost (averaged across firms) from its steady state; and expected future inflation. This relation is obtained as a log-linear approximation of the aggregated behavior of individual firms that set prices for multiple periods based on current and anticipated future nominal marginal cost, and do so on a staggered basis.

The second key building block is an equation that has real marginal cost vary proportionately with the output gap, where the latter is defined as the percent deviation of output from its natural (flexible price equilibrium) level. This second relation holds explicitly in the model under certain auxiliary assumptions, including in particular the assumption of competitive labor markets. Intuitively, periods of excess demand (output above the natural level) are associated with marginal cost above average, and the reverse is true for periods of excess supply.

Combining these fundamental relations yields the baseline NKPC: inflation depends on the output gap and anticipated future inflation. Note that the NKPC has some of the flavor of a traditional Phillips curve in the sense that inflation varies positively in the short run with the output gap. The similarity stops there, however. The defining property of the baseline NKPC is the forward looking nature of inflation dynamics. The NKPC is effectively a first-order...