Assessing the sensitivity of inflation to economic activity

Alistair Dieppe (), Eva Ortega, Antonello D'Agostino, Tohmas Karlsson, Konstantins Benkovskis, Michele Caivano, Samuel Hurtado and Tímea Várnai

No 1357, Working Paper Series from European Central Bank

Abstract: A number of academic studies suggest that from the mid-1990s onwards there were changes in the link between inflation and economic activity. However, it remains unclear the extent to which this phenomenon can be ascribed to a change in the structural relationship between inflation and output, as opposed to a change in the size and nature of the shocks hitting the economy. This paper uses a suite of models, such as time-varying VAR techniques, traditional macro models, as well as DSGE models, to investigate, for various European countries as well as for the euro area, the evolution of the link between inflation and resource utilization and its dependence on the nature and size of the shocks. Our analysis suggests that the relationship between inflation and activity has indeed been changing over time, while remaining positive, with the correlation peaking during recessions. Quantitatively, the link between output and inflation is found to be highly dependent on which type of shocks hit the economy: while, in general, all demand shocks to output imply a reaction of inflation of the same sign, the latter will be less pronounced when output fluctuations are driven by supply shocks. In addition, a sharp deceleration of activity, as opposed to a subdued but protracted slowdown, results in a swifter decline in inflation. Inflation exhibits a rather strong persistence, with a negative impact still visible three years after the initial shock. JEL Classification: E31, E32, E37

Keywords: demand shock; inflation response; Macro model; output growth; Phillips curve (search for similar items in EconPapers)
Date: 2011-06
New Economics Papers: this item is included in nep-cba, nep-dge, nep-eec, nep-mac and nep-mon
Note: 95834
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

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Persistent link: https://EconPapers.repec.org/RePEc:ecb:ecbwps:20111357

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