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Unclassified ECO/WKP(99)11 Unclassified ECO/WKP(99)11 Organisation de Coopération et de Développement Economiques OLIS : 27-Jul-1999 Organisation for Economic Co-operation and Development Dist. : 04-Aug-1999 __________________________________________________________________________________________ English text only ECONOMICS DEPARTMENT Unclassified ECO/WKP(99)11 TESTING FOR A COMMON OECD PHILLIPS CURVE ECONOMICS DEPARTMENT WORKING PAPERS N0. 219 by Dave Turner and Elena Seghezza Most Economics Department Working Papers beginning with No. 144 are now available through OECD's Internet Web site at http://www.oecd.org/eco/eco. English text only 80257 Document complet disponible sur OLIS dans son format d'origine Complete document available on OLIS in its original format ECO/WKP(99)11 ABSTRACT/RÉSUMÉ This paper reports estimates of a reduced form relationship explaining inflation in terms of the output gap and import price inflation for most OECD countries. Results are reported both for single equation estimation on a country-by-country basis and using a system estimation technique in order to impose common parameters across countries where such restrictions are consistent with the data. A striking feature of the results is that most of the countries accept a common sacrifice ratio. ************ Ce papier présente des estimations de formes réduites d'inflation pour les pays de l'OCDE. Les principales variables explicatives sont l'écart au potentiel et l'inflation importée. Deux approches économétriques sont utilisées : des estimations pays par pays, puis une estimation en système qui permet de tester et éventuellement d'imposer la similarité des coefficients à travers les pays. Le résultat le plus intéressant de cette approche est que l'on obtient ainsi des estimations de ratios de sacrifice de même ampleur pour un grand nombre de pays de l'OCDE Copyright: OECD, 1999 Applications for permission to reproduce or translate all, or part of, this material should be made To: Head of Publications Service, OECD, 2 rue André-Pascal, 75775 PARIS CEDEX 16, France 2 ECO/WPK(99)11 TABLE OF CONTENTS TESTING FOR A COMMON OECD PHILLIPS CURVE 4 Introduction and Summary 4 The Phillips curve specification 5 Estimation procedure 7 Single equation OLS estimation results 8 System estimation results 9 Conclusions 10 Tables 1. Summary of final OLS price equation results for individual countries 12 and 13 2. A. Summary of system estimation results: G7 countries 14 B. Summary of system estimation results: smaller OECD countries 14 3. Wald tests of restrictions imposed in the system estimation 15 Figures 1. Estimates of the sacrifice ratio 16 2. System residuals 17 3. Inflation response to a temporary increase in the output gap for the G7 countries based on system estimates 18 4. Inflation response to a temporary increase in the output gap for the smaller OECD countries based on system estimates 18 5. Output price response to a permanent increase in the import price level by one per cent for the G7 countries based on system estimates 19 6. Output price response to a permanent increase in the import price level for the smaller OECD countries based on system estimates 19 7. Real wage resistance in the United States, Japan and the European Union 20 REFERENCES 21 3 ECO/WPK(99)11 TESTING FOR A COMMON OECD PHILLIPS CURVE Dave Turner, Elena Seghezza1 Introduction and Summary 1. Globalisation and rapid technological change are increasingly cited as undermining conventional macroeconomic relationships that attempt to explain inflation.2 Evidence to the contrary is provided by this paper which shows that a simple Phillips curve relationship works well for most OECD countries, remaining stable over recent years, with a high degree of similarity in the estimated parameters across many countries. The key explanatory variable is a measure of the output gap that is published regularly in the OECD Economic Outlook, and which provides a basis of analysis and commentary on macroeconomic developments in OECD countries. The other important explanatory variable is imported inflation, to which there is some evidence that inflation in the larger European countries is more sensitive (even allowing for differences in openness) than either the United States or Japan, possibly reflecting differences in real wage resistance. 2. The Phillips curve relationship is one of the most important and controversial in macroeconomics. The original Phillips curve (Phillips, 1958) was attacked by Friedman (1968) for its prediction of a long-run trade-off between inflation and unemployment and dismissed by Lucas and Sargent (1978) as “being econometric failure on a grand scale”. Subsequently, the re-specification of the Phillips curve to incorporate a vertical long-run trade-off and supply shocks led Gordon (1997) to claim that the empirical stability of such a relationship is such that “[t]he inflation process in the United States is one of the most important macroeconomic phenomena in the world, but it is also one of the best understood”. However, even in the context of the United States, others have recently questioned the validity of the Phillips curve; for example, Galbraith (1997) argues that the empirical evidence for a vertical long-run Phillips curve is weak and has become weaker over the last decade. 3. The present paper examines the strength of the empirical evidence of a Phillips curve relationship between price inflation, the output gap and import inflation across twenty-one OECD countries. It further considers whether there is enough cross-country similarity in the relationship for common parameter restrictions to be imposed. The estimation work is conducted in two stages. In the first stage a simple Phillips curve specification is estimated separately across twenty-one OECD countries and the results examined for robustness and in particular the statistical significance of pressure of demand effects. In the 1. Both authors are members of the Macroeconomic Analysis and Systems Management Division. Thanks to Jan-Cathryn Davies and Laurence Le Fouler for technical preparation and Jorgen Elmeskov, Pete Richardson and Stefano Scarpetta for comments on an earlier draft, although we accept sole responsibility for any remaining errors. 2. See the discussion in Gordon (1998), who is sceptical of such claims. 4 ECO/WPK(99)11 second stage the individual country equations are subjected to a system estimation approach, and tests are conducted to see how far common coefficient restrictions can be imposed across different countries. 4. The remainder of the paper is organized as follows. The first section describes the traditional specification used in the empirical literature on the Phillips curve and the particular specification adopted in this paper. The second section describes the estimation procedure. The third and fourth sections describe the single equation and system estimation results, respectively. Conclusions follow. The Phillips curve specification 5. The “Phillips curve” is here taken, as in Gordon (1997), to describe “a generic term for any relation between the rate of change of a nominal wage or price and the level of a real indicator of demand in the economy”. Gordon (1997) refers to the re-interpretation of the original Phillips curve to incorporate supply shocks and no long run trade-off as the “triangle” model of inflation whereby inflation depends on three basic determinants: inertia, demand and supply. This is the basis for the following general specification: π = a(L) π-1 + b(L) D + c(L) z + e [1] where the dependent variable is the inflation rate, inertia is captured by the lags of inflation, D is a measure of excess demand, z is a vector of supply shocks variables, a(.), b(.) and c(.) are polynomials in the lag operator L, subscripts denote lags and e is a serially uncorrelated error term. The restriction that the sum of the coefficients on lagged inflation values equals unity is imposed to ensure there is no long run trade-off between inflation and excess demand. 6. Different researchers have used different measures of excess demand D to estimate a Phillips curve relationship, including measures of labour market slack and capacity utilisation. As previously noted, the variable used here is the OECD Secretariat measure of the output gap, defined as the percentage difference between actual and potential real GDP, where the methodology underlying the calculation of potential output is described in Giorno et al. (1995). 7. The traditional Phillips curve specification of the 1960s and early 1970s did not include supply shock variables. This creates a potential omitted variables problem, because supply shocks, for example a sharp rise in energy prices, can create a negative correlation between inflation and the output gap implying a downward bias in the estimated coefficient on the output gap. Hogan (1998) finds that recent US inflation performance can only be adequately explained by a Phillips curve relationship when supply shocks arising from import price movements are incorporated into the specification. Following Hogan (1998), Gruen, Pagan and Thompson (1998) and Turner (1995), the equations estimated in this paper include an effect from imported inflation, which is arguably one of the most important supply shocks. 8. The original Phillips curve explained wage inflation, although many subsequent empirical applications, including the current paper, have been formulated in terms of price inflation. Gordon (1997) argues for the use of prices in the context of the United States partly on the grounds that this is of greater policy interest because price inflation is more clearly one of the ultimate targets of macro policy. 9. An omission from the general specification [1] is any explicit reference to price expectations. Even if expectations can be revised promptly, price adjustment can be delayed by wage and price contracts, and by the time needed for cost increases to pass through the various intermediate stages of production. 5 ECO/WPK(99)11 The role of the lagged inflation terms is to capture the dynamics of inertia, whether related to expectation formation, contracts, delivery lags or anything else.3 10.
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