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The flattening of the Phillips curve: Rounding up the suspects

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Abstract
The Phillips curve embodies the relationship between measures of inflation and economic activity. This correlation has declined over time in New Zealand and other developed economies, a phenomenon commonly known as the flattening of the Phillips curve. This paper provides a framework to think about the potential causes of the waning correlation between inflation and activity in New Zealand. Does this declining correlation imply that prices have become less volatile due to price-setting by firms becoming less sensitive to demand pressures? Has demand become less volatile due to households becoming less responsive to the interest rate? Have the random disturbances influencing aggregate supply and demand changed? We first run computational experiments in a simple model of demand and supply to demonstrate how the declining correlations observed in the data can be generated by two causal mechanisms: changes in the behaviour of economic actors or changes in the composition of random business cycle disturbances hitting the economy. The key message of the experiment is that if disturbances influencing the supply side of the economy are more potent than those affecting the demand side, the correlation between inflation and activity can diminish. In the next step, we estimate an extended version of the model on New Zealand data to point out potential reasons for the flattening of the Phillips curve over the inflation targeting era. Our methodology does not isolate any particular feature as a single dominant driver of the diminishing correlations observed in the data. Instead, we identify a number of potential mechanisms that contribute to the flattening of the Phillips curve. Our results suggest that changes in the structure of the economy have been fairly mild. However, business cycle disturbances on the supply side have been become much more variable than those influencing the demand side. These supply-side disturbances are very influential in driving the waning correlation between inflation and activity.

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  • Punnoose Jacob & Thomas van Florenstein Mulder, 2019. "The flattening of the Phillips curve: Rounding up the suspects," Reserve Bank of New Zealand Analytical Notes series AN2019/06, Reserve Bank of New Zealand.
    • Handle: RePEc:nzb:nzbans:2019/06
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    References listed on IDEAS

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    1. John M. Roberts, 2006. "Monetary Policy and Inflation Dynamics," International Journal of Central Banking, International Journal of Central Banking, vol. 2(3), September.
    2. Güneş Kamber & Chris McDonald & Nicholas Sander & Konstantinos Theodoridis, 2015. "A structural model for policy analysis and forecasting: NZSIM," Reserve Bank of New Zealand Discussion Paper Series DP2015/05, Reserve Bank of New Zealand.
    3. Jacob, Punnoose & Munro, Anella, 2018. "A prudential stable funding requirement and monetary policy in a small open economy," Journal of Banking & Finance, Elsevier, vol. 94(C), pages 89-106.
    4. Doyle, Matthew & Beaudry, Paul, 2000. "What Happened to the Phillips Curve in the 1990s in Canada," Staff General Research Papers Archive 10286, Iowa State University, Department of Economics.
    5. Kuttner, Ken & Robinson, Tim, 2010. "Understanding the flattening Phillips curve," The North American Journal of Economics and Finance, Elsevier, vol. 21(2), pages 110-125, August.
    6. Edward P. Herbst & Frank Schorfheide, 2016. "Bayesian Estimation of DSGE Models," Economics Books, Princeton University Press, edition 1, number 10612.
    7. Jordi Galí, 2015. "Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New Keynesian Framework and Its Applications Second edition," Economics Books, Princeton University Press, edition 2, number 10495.
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    1. David Finck & Peter Tillmann, 2022. "The Role of Global and Domestic Shocks for Inflation Dynamics: Evidence from Asia," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 84(5), pages 1181-1208, October.
    2. Carlos Medel, 2021. "Forecasting Brazilian Inflation with the Hybrid New Keynesian Phillips Curve: Assessing the Predictive Role of Trading Partners," Working Papers Central Bank of Chile 900, Central Bank of Chile.
    3. Harsha Paranavithana & Leandro Magnusson & Rod Tyers, 2021. "Monetary Policy Regimes in Small Open Economies: The Case of Sri Lanka," Asian Economic Journal, East Asian Economic Association, vol. 35(4), pages 434-462, December.
    4. Aquino, Juan, 2019. "The Small Open Economy New-Keynesian Phillips Curve: Specification, Structural Breaks and Robustness," Working Papers 2019-019, Banco Central de Reserva del Perú.

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