DP12981 Optimal Inflation and the Identification of the Phillips Curve

Author(s): Michael McLeay, Silvana Tenreyro
Publication Date: June 2018
Keyword(s): identification, Inflation targeting, Phillips curve
JEL(s):
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=12981

This paper explains why inflation follows a seemingly exogenous statistical process, unrelated to the output gap. In other words, it explains why it is difficult to empirically identify a Phillips curve. We show why this result need not imply that the Phillips curve does not hold – on the contrary, our conceptual framework is built under the assumption that the Phillips curve always holds. The reason is simple: if monetary policy is set with the goal of minimising welfare losses (measured as the sum of deviations of inflation from its target and output from its potential), subject to a Phillips curve, a central bank will seek to increase inflation when output is below potential. This targeting rule will impart a negative correlation between inflation and the output gap, blurring the identification of the (positively sloped) Phillips curve.