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
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: 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 รข?? 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.