ANNEX Phillips Curve and Okun’s Law Estimates
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This paper was prepared by Craig Beaumont (APD). I thank Bank of Korea staff for comments on an earlier version of the paper at a seminar in Seoul on November 10, 2003 and Junhan Kim, BOK Research Department, for comments on this version.
The target was set in terms of the annual average inflation rate, i.e., the percent change in the arithmetic average CPI index in January-December of one year compared with the previous year.
The quarterly output gap was estimated by a Kalman filter approach, treating the gap as an unobserved autoregressive component, using STAMP 5.0, Koopman et al. (1995).
Okun’s Law is a relationship between the cyclical components of GDP and unemployment. The variant estimated in this paper focuses on actual unemployment and real GDP growth. To allow for possible changes in the NAIRU or potential growth, various trends are tested in the estimated equation.
BOK survey data on inflation expectations supports the hypothesis that expectations are quite inertial. Chart 2 of Yu (2002) shows data on average inflation expectations in 1998, 1999, and 2000, and these are little changed despite the rise in inflation during this time.
This strong mean reversion may reflect a combination of two forces: (i) unemployment affecting real wages and thus the strength of employment growth relative to real GDP growth; (ii) a discouraged worker effect, where the long-term unemployed exit the labor force, reducing unemployment. A more structural analysis of labor demand and supply would be needed to evaluate the relative significance of these two factors.
The projections are dynamic, using projected values for lagged dependent terms, so the standard error bands widen over the forecast horizon. This effect is more important in the Okun’s Law equation due to the large coefficient on lagged unemployment.
Dynamic simulations use actual values for exogenous variables, but projected levels of any endogenous variables including lags of the dependent.
The naive models were estimated as a structural time series equation within STAMP 5.0, Koopman et al. (1995).
These projections incorporate preliminary official estimates of real GDP growth in 2003 Q4 of 3½percent q/q, which implies a high rate of annualized growth of 15 percent.
No explicit monetary policy assumption is made. The real GDP growth projection assumes that monetary policy remains supportive of economic recovery.
Data on the core CPI excluding public service charges is available since 1985, and allowing for lags, the sample for estimation of the Phillips curve could begin in 1986. When the chosen specification is estimated over 1986–2003, the parameters are similar and statistically significant. However, the residual volatility in the late 1980s is much higher, at 0.56 percent compared with 0.29 percent from 2000 on. This period, which coincides with a boom in the housing market, was dropped from the sample.