Ball, Laurence, and N. Gregory Mankiw, “Asymmetric Price Adjustment and Economic Fluctuations.” Economic Journal, Vol. 104 (March 1994), pp. 247–61.
Bryant, Ralph C., Peter Hooper, and Catherine L. Mann. eds., Evaluating Policy Regimes: New Research in Empirical Macroeconomics (Washington: The Brookings Institution, 1993).
Calvo, Guillermo A., “Staggered Prices in a Utility–Maximizing Framework,” Journal of Monetary Economics, Vol. 12 (September 1983). pp. 383–98.
Chan, Irene, and others, “Asymmetric Price Adjustment in the G‐7 Economies” (unpublished; Washington: International Monetary Fund. July 1994).
Chadha, Bankim, Paul R. Masson, and Guy Meredith “Models of Inflation and the Costs of Disinflation,” Staff Papers, International Monetary Fund, Vol. 39 (June 1992), pp. 395–431.
De Long, J. Bradford, and Lawrence H. Summers, “How Does Macroeconomic Policy Affect Output?” Brookings Papers on Economic Activity: 2 (1988), The Brookings Institution, pp. 433–80.
Hodrick, Robert, and Edward C. Prescott, “Postwar U.S. Business Cycles: An Empirical Investigation,” Carnegie‐Mellon University, Department of Economics Working Paper No. 451 (Pittsburgh, Pennsylvania: Carnegie‐Mellon University, November 1980).
Laxton, Douglas, Guy Meredith, and David Rose, “Asymmetric Effects of Economic Activity: Evidence and Policy Implications,” IMF Working Paper 941139 (Washington: International Monetary Fund, November 1994).
Laxton, Douglas, Nicholas Ricketts, and David Rose, “Uncertainty, Learning and Policy Credibility” in Economic Behaviour and Policy Choice Under Price Stability (Ottawa: Bank of Canada, August 1993).
Laxton, Douglas, David Rose. and Robert Tetlow (1993a), “Problems in Identifying Non‐Linear Phillips Curves: Some Further Consequences of Mismeasuring Potential Output,” Bank of Canada Working Paper 93–6 (Ottawa: Bank of Canada. June 1993).
Laxton, Douglas, (1993b), “Is the Canadian Phillips Curve Non‐Linear?” Bank of Canada Working Paper 93–7 (Ottawa: Bank of Canada, July 1993).
Laxton, Douglas, (1993c). “Monetary Policy, Uncertainty and the Presumption of Linearity,” Bank of Canada Technical Report No. 63 (Ottawa: Bank of Canada, August 1993).
Laxton, Douglas, and Robert Tetlow, Government Debt in an Open Economy, Bank of Canada Technical Report No. 58 (Ottawa: Bank of Canada, 1992).
Masson, Paul R., and Guy Meredith, “Economic Implications of German Unification for the Federal Republic and the Rest of the World,” IMF Working Paper 90185 (Washington: International Monetary Fund, September 1990).
Masson, Paul R., Steven Symansky, and Guy Meredith, MULTIMOD Mark 11: A Revised and Extended Model, IMF Occasional Paper No. 71 (Washington: International Monetary Fund. July 1990).
Mauskopf, Eileen, “The Transmission Channels of Monetary Policy: How Have They Changed?” Federal Reserve Bulletin, Board of Governors of the U.S. Federal Reserve System, Vol. 76 (December 1990), pp. 985–1008.
McKibbin, Warwick J., and Jeffrey D. Sachs, Global Linkages: Macroeconomic Interdependence and Cooperation in the World Economy (Washington: The Brookings Institution, 1991).
Phillips, A. W., “The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861–1957,” Economica, Vol. 25 (November 1958), pp. 283–99.
Poole, William, “Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model,” Quarterly Journal of Economics, Vol. 84 (May 1970), pp. 197–216.
Rotemberg, Julio J., “The New Keynesian Microfoundations,” in NBER Macroeconomics Annual 1987, ed. by Stanley Fischer (Cambridge: MIT Press, 1987), pp. 69–104.
Summers, Lawrence H., “Should Keynesian Economics Dispense with the Phillips Curve?” in Unemployment, Hysteresis and the Natural Rate Hypothesis, ed. by Rod Cross (New York: Basil Blackwell, 1988), pp. 11–25.
Tsiddon, Daniel, “The (Mis)Behaviour of the Aggregate Price Level.” Review of Economic Studies, Vol. 60 (October 1993), pp. 889–902.
Douglas Laxton is an Economist in the Research Department. Guy Meredith is a Division Chief in the Central Asia Department. They did their graduate work at the University of Western Ontario. David Rose is a Research Adviser at the Bank of Canada. He received a doctorate from the University of Manchester. Irene Chan, currently a graduate student at Queen’s University, worked with the authors in the first phase of this research and co‐authored a paper reporting preliminary estimation results. This paper has benefited from helpful comments by Bijan Aghevli, Tamim Rayoumi, Bankim Chadha, Peter Clark, and Steven Symansky.
See, for instance, De Long and Summers (1988) for evidence on asymmetries in business cycles characteristic of such nonlinearities.
In what follows, we use the relationship
Less plausibly, this function also implies a region in which downward pressure on inflation declines as excess supply increases beyond a certain level.
The effect on inflation should have the same sign as the output gap itself, which would not be the case if the gap were raised to an even power.
See Masson and Meredith (1990) for an example of the estimation of this functional form for the G‐7 countries.
The actual function estimated by LRT also had a quadratic term in the region of positive excess demand that generated increasing marginal pressure on inflation.
From a policy perspective, this function implies that the average level of output is independent of its variance, negating a role for policies designed to smooth demand fluctuations.
A more formal justification for the presence of lagged inflation is given by Taylor (1980) in a model of overlapping wage contracts expressed in growth rates
We use the term “potential” output to refer to the level of output at which there is no tendency for inflation to either rise or fall. It should be emphasized, though, that this definition of potential will not correspond to the average attainable level of output in a stochastic economy.
The measure of potential output that enters the Phillips curve would only be attainable in a world without shocks. Since positive gaps have greater effects on inflation than negative gaps, the expected value of the output gap that enters the Phillips curve has to be negative for inflation to be stationary (see De Long and Summers (1988) and Laxton, Rose, and Tetlow (1993c)).
See, for instance, the derivation of CMM’s equation (4).
For a description of MULTIMOD. see Masson, Symansky, and Meredith (1990). The database is constructed primarily from conventional national accounts data for the G‐7 countries; non‐oil GDP deflators are derived using OECD data on oil production for the 0‐7 countries.
In other words,
All these variables were obtained from the MULTIMOD database.
Laxton. Rose, and Tetlow (1993a) demonstrate using Monte Carlo techniques that statistical tests have been biased against finding convexity because researchers have typically employed mean‐square‐error criteria to measure the output gap. The intuition behind this bias is as follows. If excess demand is more inflationary than excess supply is deflationary, the noninflationary level of output must he greater than its mean level (see Appendix I of an earlier version of this paper—Laxton, Meredith, and Rose (1994)). If a mean‐squared‐error criterion is used to measure the latter, estimates of excess supply will be too small, on average, while estimates of excess demand will be too large. In the artificial economies studied by Laxton, Rose, and Tetlow (1993a), this measurement bias substantially reduced the power of statistical tests of nonlinearities. The approach used in this paper to dealing with this issue is discussed below.
As discussed above, the linear function is simply a nested version of the CMM function with the parameter ω set to infinity.
As discussed in Section 11, this provides a measure of the amount by which the average level of output was lowered over the sample period by the volatility of shocks to aggregate demand.
These results are consistent with the hypothesis that the linear specification is more robust to the mismeasurement of potential.
Such a result is also consistent with the Monte Carlo evidence reported in Laxton, Rose, and Tetlow (1993b).
Indeed, when the lagged effects of the policy instrument exceed the contemporaneous effect, attempts to fully offset demand shocks will generally lead to “instrument instability,’ characterized by explosive oscillations in interest rates.
The estimation of equation (9) using annual data is complicated by an identification problem: real interest rates tend to rise in the face of positive shocks to aggregate demand, generating a positive correlation between the contemporaneous real interest rate and the disturbance term. The use of higher frequency data gets around this problem to a large extent by more efficiently “time‐ordering” the relationship between output and interest rates. The quarterly estimation results for the output equation are reported in Appendix 11 of an earlier version of this paper—see Laxton, Meredith, and Rose (1994).
See Mauskopf (1990) for a discussion of the properties of this model and Appendix III of our 1994 working paper for a comparison with other models.
Model‐consistent means that
Since the monetary target is expressed in terms of inflation as opposed to the price level, there is also cumulative drift in prices. As shown in Figure 4f, this drift amounts to 1¼ percent when the monetary authorities react by raising interest rates immediately versus 3¼ percent when they delay the increase in short‐term interest rates.