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Prepared by D. Laxton.
For example, Chairman Greenspan in recent testimony before the Congress explained that “In modern economies output levels may not be so rigidly constrained in the short run as they used to be when large segments of output were governed by facilities such as the old hearth steel furnaces that had rated capacities that could not be exceeded for long without breakdown. Rather, the appropriate analogy is a flexible ceiling that can be stretched when pressed, but as the degree of pressure increases, the extent of the flexibility diminishes.”
In the discussion below output gaps are defined such that positive values are associated with excess demand and upward pressure on inflation. Some researchers follow Arthur Okun’s convention and define gaps the other way round.
See for example, Clark, Laxton, and Rose (1995).
Eisner’s model uses unemployment gaps. He finds that a reduction in unemployment is less inflationary if the economy is booming and unemployment is initially below the natural rate than if unemployment is initially above the natural rate. The statement in the text assumes that there is a direct relationship between excess demand conditions in the goods market and excess demand conditions in the labor market.
See Buiter and Miller (1985) or Fuhrer and Moore (1994) for further discussion of these issues.
This simple functional form can be thought of as a linear approximation to a more general convex function.
Clark, Laxton, and Rose (1995a) provide a formal proof of this in a more general model with convexity in the aggregate supply curve. However, the intuition is simple. Suppose that excess demand gaps raise inflation by twice as much as negative gaps reduce it. In such a case, a positive one percent gap that raised inflation would have to be followed by a cumulative negative gap of 2 percent in order to reestablish inflation at its initial level. If this occurred over two periods, the sum of the gaps would be -1.0 percent and the mean value of the gap over these two periods would be -0.5 percent.
Output is measured in logarithms to prevent phase shift that arises from growth. If it was not measured in logarithms, gaps constructed with symmetric two-sided filters would not have a zero mean in large samples.
See Eichenbaum (1990) for an excellent discussion about why our econometric techniques cannot provide very reliable estimates of the relative variance of demand versus supply shocks. Clark, Laxton, and Rose (1995a) show that similar evidence in favor of asymmetries is obtained when one uses other methods that have been advocated in the past to detrend U.S. output.
This choice of lag structure doesn’t affect the results. The same results are obtained if an unrestricted model with 4 lags on inflation and inflation expectations is estimated or if a triangular distribution on lagged inflation expectations is imposed.
The propagation of demand shocks is represented by a second-order autoregressive structure. All else equal, the effects of a shock are amplified in the second period and then die out slowly. These properties are roughly consistent with the evidence from both reduced-form models of the transmission mechanism (e.g. Roberts 1994a) and more structural models (e.g., Mauskaupf 1990).
The simulations reported here are deterministic. Although these types of experiments are useful for developing the basic intuition behind the model, they do not do justice to the full policy implications--see Clark, Laxton, and Rose (1995) for a more extensive analysis of the policy implications of asymmetry in inflation dynamics in a stochastic environment.