Abstract: The simultaneous occurrence in the second half of the 1990s of
low and falling price inflation and low unemployment appears to be
at odds with the properties of a standard Phillips curve. We find
this result in a model in which inflation depends on the
unemployment rate, past inflation, and conventional measures of
price supply shocks. We show that, in such a model, long lags of
past inflation are preferred to short lags, and that with long lags,
the NAIRU is estimated precisely but is unstable in the 1990s. Two
alternative modifications to the standard Phillips curve restore
stability. One replaces the unemployment rate with capacity
utilization. Although this change leads to more accurate inflation
predictions in the recent period, the predictive ability of the
utilization rate is not superior to that of the unemployment rate
for the 1955 to 1998 sample as a whole. The second, and preferred,
modification augments the standard Phillips curve to include an
"error-correction" mechanism involving the markup of prices over
trend unit labor costs. With the markup relatively high through
much of the 1990s, this channel is estimated to have held down
inflation over this period, and thus provides an explanation of
the recent low inflation.
Keywords: Inflation, NAIRU, Phillips curve
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