Asymmetric Effects of Economic Activityon Inflation: Evidence and Policy Implications

IMF Working Papers, November 1, 1994

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Canonical URL: Asymmetric Effects of Economic Activityon Inflation: Evidence and Policy Implications

The paper examines evidence on asymmetries in the effects of activity on inflation.
Data for the G-7 countries strongly support a nonlinear inflation-activity relationship: high levels of activity raise inflation by more than low levels of activity decrease it.
In economies subject to demand shocks, the average level of output will be below the level of output at which there is no tendency for inflation to rise or fall, contrary to linear-model implications.
A policy implication is that policymakers can raise the average level of output over time by responding promptly to demand shocks, thereby reducing the variance of output around trend.

Nonlinearity in the output-inflation relationship is supported by G-7 country data.
Asymmetry implies asymmetric costs of positive versus negative deviations of activity from trend: inflation rises more with high activity than it falls with low activity.
Under asymmetry, the conventional linear model implication that mean output equals the no-inflation-tendency output does not hold.

Prompt policy responses to demand shocks can:
- Raise the average level of output over time.
- Reduce the variance of output around trend.
Policy should account for nonlinear/asymmetric output-inflation tradeoffs when designing stabilization responses.

Subjects: Deflation, Financial services, Inflation, Output gap, Potential output, Prices, Production, Real interest rates, Short term interest rates
Keywords: aggregate demand, excess demand, Inflation, inflation expectation, monetary policy, Output gap, output-inflation relationship, output-inflation tradeoff, Phillips curve, Potential output, real GDP, Real interest rates, Short term interest rates, WP