Is the Phillips Curve Really a Curve? Some Evidence for Canada, the United Kingdom, and the United States


WP/96/111-EA

Is the Phillips Curve Really a Curve?
Some Evidence for Canada, the United Kingdom,
and the United States by Guy Debelle and Douglas Laxton


Previous tests for convexity in the Phillips curve have been biased
because researchers have employed filtering techniques for the
nonaccelerating inflation rate of unemployment (NAIRU) that have been
fundamentally inconsistent with the existence of convexity. A preferred
statistical methodology would place both the linear and nonlinear models on
an equal statistical footing by estimating model-consistent measures of the
NAIRU.

This paper proposes a Kalman filter maximum likelihood procedure to
simultaneously estimate the parameters of the model along with model-
consistent estimates of the NAIRU. A novel feature of the study is that
information is used from bond markets to develop measures of inflation
expectations. With plausible restrictions imposed on the variance of the
NAIRU, it is found that the nonlinear model fits the data better for Canada,
the United Kingdom, and the United States.

The paper demonstrates that asymmetry in the unemployment-inflation
process has important policy implications. Stabilization policies that are
not very successful at reducing the variability in the business cycle can
have very undesirable consequences, not only for the variance of
unemployment but also for the natural rate of unemployment. Uncertainty
about the true level of the NAIRU reinforces the case for adopting a
cautionary strategy of raising interest rates before the economy reaches
potential. It may thus be optimal in the context of uncertainty to develop
a strategy that attempts to avoid large boom-bust cycles, rather than one
that attempts to fine-tune policy to ensure that all resources are fully
employed at all points in time.