Asymmetric Effects of Economic Activity on Inflation - Evidence and Policy Implications

WP/94/139-EA
Asymmetric Effects of Economic Activity on Inflation: Evidence
and Policy Implications by Douglas Laxton, Guy Meredith, and David Rose

This paper examines the evidence on asymmetries in the relationship
between economic activity and inflation. As previous theoretical and
empirical work provides little guidance as to the form that such asymmetries
might take, alternative models are estimated using pooled Group of Seven
data for the period 1967-91. The paper finds strong evidence in favor of a
nonlinear relationship, in which the effect of excess demand in raising
inflation is much stronger than that of excess supply in reducing it. In
addition, the preferred specification implies an upper limit on the level of
output in the short run: as output approaches this level, inflationary
pressures rise without bound. The paper also shows that the absence of
strong evidence in favor of nonlinearities in previous studies may have been
due to a misspecification of the level of potential output. In particular,
in a stochastic economy with an asymmetric inflation-activity trade-off,
trend output lies below the level of output at which there is no tendency
for inflation to either rise or fall; ignoring the difference between these
two concepts is shown to reduce the power of tests of the nonlinear
hypothesis.

The existence of inflation-activity asymmetries has important
implications for demand-management policies. Simulations of a small
macroeconomic model indicate that, in a linear world, it may be desirable
for policymakers to postpone responses to positive shocks to aggregate
demand. In a nonlinear world, in contrast, it is preferable to respond
quickly to incipient inflationary pressures, as deep recessions are needed
to offset periods of mild excess demand. Minimizing the initial rise in
demand thus reduces the cumulative loss in output. This is an example of a
more general proposition about the role of demand-management policies.
Specifically, in a nonlinear world, the average level of output lies below
its potential level by an amount that depends on the variance of output and
the degree of convexity of the inflation-activity trade-off. By adopting
rules that minimize the variance of output, policymakers can raise the
average level of output of the economy over time.