Asymmetry in the U.S. Output-Inflation Nexus: Issues and Evidence
IMF Working Papers, August 1, 1995
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Bibliographic details
- Authors: Douglas Laxton, Peter B. Clark, David Rose
- Published: August 1, 1995
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451849813.001
Main findings
- Empirical evidence supports a significant asymmetry in the U.S. output-inflation process: excess demand conditions are much more inflationary than excess supply conditions are disinflationary.
- Because of this asymmetry, allowing the economy to overheat can be very costly: reestablishing inflation control may require a severe tightening in monetary conditions.
- The small model developed in the paper indicates that large recessions (for example, the 1981-82 recession) can be seeded by prior overheating of the economy.
- The appropriate measure of excess demand for estimating the Phillips curve cannot have a zero mean; the mean must be negative if inflation is to be stationary.
- Failure to account for the nonzero (negative) mean of the excess demand measure can lead researchers to be misled into falsely accepting a linear Phillips curve specification.
Model, theory, and implications
- The paper develops a small model of the U.S. output-inflation process that explicitly incorporates asymmetry between excess demand and excess supply effects on inflation.
- Key theoretical implication: asymmetry implies a nonzero mean for the excess demand measure used in Phillips curve estimation—specifically, a negative mean is required for stationary inflation.
- Policy implication: asymmetric inflationary response makes overheating particularly costly because restoring price stability requires stronger policy tightening than the disinflationary effect of equivalent negative demand shocks.
Empirical approach and robustness checks
- Empirical results demonstrate robustness of the asymmetry conclusions to:
- Changes in the method used to estimate potential output.
- Changes in the specification of the Phillips curve.
- The paper shows that sensitivity analyses support the central finding that asymmetry is a robust feature of the U.S. output-inflation nexus.
Policy recommendations and cautions
- Monetary policy should avoid allowing the economy to overheat because the asymmetric inflationary response raises the cost of subsequent stabilization.
- Empirical modeling of inflation dynamics should incorporate asymmetry and the implied negative mean of the excess demand measure to avoid misspecification and false acceptance of linear models.