Testing price equations

Abstract

a b s t r a c tHow inflation and unemployment are related in both the short run and long run is perhaps the key question in macroeconomics. This paper tests various price equations using quarterly U.S. data from 1952 to the present. Issues treated are the following. (1) Estimating price and wage equations in which wages affect prices and vice versa versus estimating ''reducedform'' price equations with no wage explanatory variables. (2) Estimating price equations in (log) level terms, first difference (i.e., inflation) terms, and second difference (i.e., change in inflation) terms. (3) The treatment of expectations. (4) The choice and functional form of the demand variable. (5) The choice of the cost-shock variable. The results suggest that the best specification is a price equation in level terms imbedded in a price-wage model, where the wage equation is also in level terms. The best cost-shock variable is the import price deflator, and the best demand variable is the unemployment rate. There is some evidence of a nonlinear effect of the unemployment rate on the price level at low values of the unemployment rate. Many of the results in this paper are contrary to common views in the literature, but the empirical support for them is strong.

A new Keynesian triangle Phillips curve

“…A related issue is the choice of instruments. Fair (2008) argues that the instruments that are used to estimate the new Keynesian Phillips curve, such as higher lags of in ‡ation, output gap, commodity prices, etc., are invalid because "the lagged values are not part of the model and so theoretically are not appropriate to use". The lack of a robust criterion that should guide the choice of instruments remains a major problem that may be responsible for con ‡icting results in the literature, despite the proposals by Andrews (1999), Donald and Newey (2001), Kapetanios (2006) and Hwang and Kim (2012).…”

A Traditional Nominal Wage Phillips Curve: Theory and Evidence

“…In addition, Gordon (1997) argues that models with a separate price and wage growth equation do not perform as well as the triangle model. This assertion is disputed by Fair (2008), who finds that a system that specifies separate price and nominal wage equations performs better than Gordon's triangle Phillips curve in forecasting inflation. This means that the wage equation contains information about the dynamics of the price level.…”

“…We think that the criticisms of the new Keynesian price Phillips curve are likely to carry over to its nominal wage counterpart. For example, Rudd and Whelan (2005, 2007) and Fair (2008) do not find significant empirical forward‐looking behaviour in the expectations formation process for the price Phillips curve. Second, Gordon (2011) finds that the new Keynesian Phillips curve produces very poor dynamic forecasts of the price inflation rate while the backward‐looking Phillips curve does a very good job in this regard.…”

Predicting Inflation Dynamics with Singular Spectrum Analysis

“…energy prices) and inflation ‘inertia’ (lagged inflation), as well as the new Keynesian Phillips curve. We refer interested readers to Rudd and Whelan (2007) for excellent discussions of the development of the Phillips curve analysis, and to Fair (2008) on empirical estimations of alternative Phillips curve‐based models.…”