Instability of the Inflation–Output Trade‐Off and Time‐Varying Price Rigidity

AuthorValérie Mignon,Antonia López‐Villavicencio
Date01 October 2015
Published date01 October 2015
DOIhttp://doi.org/10.1111/obes.12102
634
©2015 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd.
OXFORD BULLETIN OF ECONOMICSAND STATISTICS, 77, 5 (2015) 0305–9049
doi: 10.1111/obes.12102
Instability of the Inflation–Output Trade-Off and
Time-Varying Price Rigidity*
Antonia L ´
opez-Villavicencio† and Va l ´
erie Mignon
GATE-CNRS, University Lumi`ere Lyon 2, France (e-mail: lopez@gate.cnrs.fr)
EconomiX-CNRS, University of Paris Ouest, and CEPII, Paris, France (e-mail:
valerie.mignon@u-paris10.fr)
Abstract
This paper studies the time instability of the Phillips curve by paying particular attention to
the inflation environment and price stickiness. We identify various inflation episodes and
investigatethe changing nature of the cur ve across these periods for fiveadvanced countries
over 1960–2013. We show that the mean inflation, the slope of the curve and the threshold
mean inflation that erodes price rigidity are time varying. The inflation environment is a
key determinant of the inflation–output relationship, rejecting the evidence of a flat curve
and restoring the inflation–output trade-off above certain inflation thresholds.
I. Introduction
The dynamics of inflation have changed significantly in most economies over the past
decades, leading to a renewal of interest for the Phillips curve in the literature.1Most of this
growing empirical and theoretical literature highlights that inflation (i) is highly persistent
(Barsky, 1987, O’Reilly and Whelan, 2005, Pivetta and Reis, 2007, among others), and
(ii) has become less responsive to fluctuations in output in recent years (e.g. Roberts, 2006;
Kuttner and Robinson, 2010; Gordon, 2011).
Alternatively, a recent body of evidence has challenged the traditional Phillips curve as
it is usually estimated. This literature recognizes, first, that failing to account for changes
in inflation regimes erroneously leads to estimate inflation as a very persistent process
(Altissimo, Ehrmann and Smets, 2006; Musso, Stracca and van Dijk, 2009; Russell and
Chowdhury, 2013). Second, it is claimed that the Phillips curve may exhibita wide range of
forms including convexity, concavityand piecewise linearity (Laxton, Rose and Tambakis,
1999; Alvarez Lois, 2000; Dolado, Maria-Dolores and Naveira, 2005). This literature puts
forward that there is price stickiness – in the sense that inflation is less responsive to
changes in the output gap – under certain economic circumstances, thus questioning the
JEL Classification numbers: E31, C22.
*We thank the Editor and twoanonymous referees for very helpful remarks and suggestions.
1For a recent survey, see Gordon (2011) and the special issues of The North American Journal of Economics and
Finance published inAugust 2010, and Economica published in January 2011.
Instability of the Phillips curve 635
traditional Phillips curve which assumes that the degree of economic slack has linear effects
on inflation (see Ball, Mankiw and Romer, 1988; Yates and Chapple, 1996; Kiley, 2000;
Stock and Watson, 2010; Ball and Mazumder, 2011 among others).
While a great body of the empirical literature supports the nonlinear hypothesis in the
inflation–output relationship,2these previous studies providelimited information regarding
the threshold level that erodes price rigidity. A few exceptions are Akerlof, Dickens and
Perry (1996, 2000), who develop a model in which downward nominal wage rigidity
leads to a long-run trade-off between inflation and output when inflation is below 3% or
unemployment is high enough. Also focusing on the United States, Ball and Mazumder
(2011) assume that inflation expectations stay fixedat a cer tain level– supposed to be 2.5%
for core consumer price index inflation – regardless of any movements in actual inflation.
Based on the behaviour of actual inflation and of expectations (as measured by the Survey
of Professional Forecasters), they find that expectations have been fully shock-anchored
since the 1980s. However, the previous definitions of low and high inflation environments
seem somewhat subjective and not derived from a for mal method.
The aim of this paper is to contribute to this ongoing debate by focusing on the instability
of the Phillips curve across various inflation environments. We identify different inflation
periods and study how the Phillips curve changes across those diverse episodes in France,
Italy, Japan, the United Kingdom and the United States over the 1960Q1–2013Q2 period.
From a methodological viewpoint,our proposed approach allows us to capture two types of
instability in the traditional backward-looking Phillips curve: shifting mean inflation and
nonlinear regime-switching process in the slope; the link between inflation and economic
activity depending on the inflation environment – low or high – in the second case. We
further test the constancy of the inflation level that erodes price rigidity.
Although it is difficult to empirically assess the functional form of the Phillips curve,
understanding price rigidity is of primary importance for monetary policy. In particular,
a few studies have accounted for asymmetries in price rigidity in the investigation of
optimal monetary policy. Orphanides and Wieland (2000) and Dolado et al. (2005) show
that monetary policy should be nonlinear if the Phillips curve is nonlinear. Indeed, if the
Phillips curve remains flat until inflation reaches a certain level, it could be easier to control
inflation when the latter is low, since adjustments to excess demand are slower. Likewise,
when inflation is below the estimated thresholds, monetary authorities could stimulate
economic activity without creating inflationary pressures. However, if the slope is non-
existent or weak, the cost of reducing inflation, once established, would increase. On the
whole, the nonlinear price rigidity tends to increase the cost of disinflationary monetary
policy, while decreasing the benefit of expansionary monetary policy.
Finally, considering that only large changes in prices matter in the inflation–output
relationship is also crucial for the validity of new Keynesian models. Indeed, as it is well
known, to justify the existence of monetary policy effects on the short run, the sticky price
hypothesis has become central in the new Keynesian framework. This assumption ratio-
nalizes the existence of periods during which factors of production – typically labour – are
2See Laxton and Debelle (1996), Eisner (1997), Doyle and Beaudry (2000), Fauvel, Guay and Paquet (2002),
Dolado et al. (2005), and Ball and Mazumder (2011) among others.
©2015 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd

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