A note on the stability of the New Keynesian Phillips Curve in Europe

Abstract

This note investigates how the explanatory power of the forward-looking New Keynesian Phillips Curve evolves over time. We exploit the present-value implications of the model and use VAR forecasts to assess whether the model matches the behaviour of actual inflation in the Euro area. A set of rolling regressions shows that the model's explanatory power varies substantially over the sample. Regime changes in the underlying monetary framework, i.e. realignment crises in the European Monetary System, the Maastricht treaty and, eventually, the introduction of European Monetary Union, are reflected in a deterioration of the model's explanatory power.

Notes

¹ For a survey of the abundant empirical research on the New Keynesian Phillips Curve see the recent issue of the Journal of Monetary Economics (Vol. 52, No. 6) devoted to ‘The econometrics of the New Keynesian price equation’.

²Rudebusch (2005) finds that the apparent policy invariance of reduced forms is consistent with the magnitude of historical policy shifts and the relative insensitivity of the reduced forms of plausible macroeconomic specifications to regime shifts. Estrella and Mishkin (2005) show that some forward-looking models may be less stable than their better fitting backward-looking counterparts.

³ Following Coenen and Wieland (2005) and others, we account for the secular downward trend in inflation and the labour share over the sample period by removing a linear time trend in each time window prior to estimation.

⁴ Here we use OLS. The GMM estimator yields almost identical results.