Introducing price-setting behaviour in the Phillips Curve: the role of nonlinearities

Abstract

Based on the theoretical literature on price setting behavior, we model three distinct forms of nonlinearity that can describe the reduced-form Phillips curve: reaction asymmetry, state dependence and a mix of both. Employing these models to the G5 for the 1985-2011 period, we find that: (i) the Phillips curve is unstable and nonlinear and (ii) there exist threshold levels of inflation and capacity utilization that erode price rigidity. Our results reinforce the existence of downward price rigidity in Japan, helping to explain the puzzle of gradual deflation. In opposition, downward price flexibility is verified for U.S