Asymmetry in the U.S. Output-Inflation Nexus - Issues and EvidenceWP/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. |