Evolving Inflation Dynamics and the New Keynesian Phillips Curve

I n most industrialized economies, periods of above average inflation tend to be associated with above average economic activity, for example, as measured by a relatively low unemployment rate. This statistical relationship, known as the Phillips curve, is sometimes invoked when economic commentators suggest that monetary policy should not try to suppress signs of inflation. But this interpretation of the Phillips curve implicitly assumes that the statistical relationship is structural, that is, the relationship will not break down during periods of persistently high inflation. Starting in the mid-1960s, Friedman and Phelps argued that the Phillips curve is indeed not structural and the experience of the United States and other countries with high inflation and low GDP growth in the late 1960s and 1970s has subsequently borne out their predictions. Various theories have been proposed to explain the Phillips curve and most of these theories agree that there is no significant long-term tradeoff between inflation and the level of economic activity. One theory that provides a structural interpretation of the short-term inflation-unemployment relationship, and that has become quite popular over the last ten years among central bank economists is based on explicit models of nominal price rigidity. The most well-known example of this theory is the New Keynesian Phillips Curve (NKPC). In this article, I evaluate how well a structural NKPC can account for the changing nature of inflation in the United States from the 1950s to today. First, I document that changes in average inflation have been associated with