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Can the Phillips Curve Help Forecast Inflation?

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Abstract

During the early 1960s, many economists and policymakers believed that monetary policy could exploit a stable trade-off between the level of inflation and the unemployment rate. One version of the hypothesized trade-off, originally described by A.W. Phillips (1958) using U.K. data from 1861– 1957, implied that policymakers could permanently lower the unemployment rate by generating higher inflation. Some years later, economists Edmund Phelps (1967) and Milton Friedman (1968), argued persuasively that any such trade-off was bound to be short-lived: once people came to expect the higher inflation, monetary policy could not keep the unemployment rate permanently below its equilibrium or “natural ” level (i.e., the rate of unemployment that prevails when inflation expectations are confirmed). This claim was later borne out by the experience of the 1970s when rising U.S. inflation did not bring about the lower unemployment rates promised by the Phillips curve. On the contrary, higher inflation coincided with higher unemployment—a combination that became known as “stagflation.” Though the Phelps-Friedman argument proved to be valid, there still remained the possibility of a short-run trade-off between inflation and unemployment.This idea led to the intellectual development of the short-run (or expectations-augmented) Phillips curve, which says that short-term movements in inflation and unemployment tend to go in opposite directions.When unemployment is below its equilibrium rate (indicating a tight labor market), inflation would be expected to rise.When unemployment is above its equilibrium rate (indicating a slack labor market), inflation would be expected to fall.The equilibrium unemployment rate is often referred to as the “NAIRU, ” i.e., the Non-Accelerating Inflation Rate of Unemployment. In a recent paper, Atkeson and Ohanian (2001) challenge the usefulness of the short-run Phillips curve as a tool for forecasting inflation.This Economic Letter summarizes their results and discusses some evidence regarding the empirical instability of the short-run Phillips curve. The Atkeson-Ohanian results Atkeson and Ohanian (2001) argue that, similar to it

Topics: long-run predecessor, the short-run Phillips curve
Year: 2002
OAI identifier: oai:CiteSeerX.psu:10.1.1.194.5534
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