Asymmetry in the U.S. Output-Inflation Nexus - Issues and Evidence


WP/95/76-EA
Asymmetry in the U.S. Output-Inflation Nexus:
Issues and Evidence by Peter Clark, Douglas Laxton, and David Rose

This paper presents empirical evidence supporting the proposition that
there is a statistically significant and large asymmetry in the U.S.
Phillips curve, namely, excess demand conditions are much more inflationary
than excess supply conditions are disinflationary. This asymmetry implies
that potential output--defined as the level of output that can be attained,
on average, in an asymmetric stochastic economy--lies below what could be
attained in the same economy without shocks. The measure of excess demand
that is appropriate for an asymmetric Phillips curve, therefore, cannot have
a zero mean; rather, this mean must be negative if inflation is to be
stationary. The proper measure of excess demand needs to be taken into
account in estimation in order to obtain unbiased tests of a restriction to
linearity. Failure to do so can explain why some other researchers may have
been misled into falsely accepting the linear model. The conclusions
regarding the presence of asymmetry in the U.S. Phillips curve are shown to
be robust to a number of tests for sensitivity to changes in the
specification.

The paper sketches some of the implications of this asymmetry for
monetary policy using a small macro model calibrated to reflect the
properties of the U.S. data. Simulations of this model contrast the effects
of delaying the monetary response to a demand shock obtained from a linear
model with those from a model with the estimated asymmetric Phillips curve.
The simulations show that if the output-inflation process is linear, then
there is no strong case for a speedy monetary policy response to a shock
that creates excess demand. Dramatically different results emerge if the
economy features the type of asymmetry revealed in the estimation results,
namely, delaying the response results in higher inflation and necessitates a
significantly stronger monetary tightening to bring inflation back under
control. This model thus predicts that the seeds of large contractions are
sown when the monetary authority temporizes in dealing with rising inflation
and allows conditions of excess demand to become entrenched.

A key policy insight from the analysis is that the degree to which
potential output in a stochastic asymmetric economy lies below that
obtainable without shocks depends on the variability of output, and hence on
the degree of success of the monetary authority in stabilizing the output
cycle. Indeed, the results reported in the paper show that policies that
allow the economy to overheat periodically can have very significant
deleterious effects on the level of potential output. Moreover, because
linear models of the output-inflation process predict that the costs from
overheating are small, these results suggest that there could be significant
output costs associated with basing monetary policy on the predictions of a
linear model.