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.