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Economic Quarterly

Summer 2004

Predicting the Recent Behavior of Inflation Using Output Gap-Based Phillips Curves

Yash P. Mehra

In order to investigate the potential anti-inflationary consequences of acceleration of productivity, the output gap-based Phillips curve is augmented to include the cyclical markup and change in output gap. The markup allows for the short-term influence of productivity-induced decline in unit labor costs on inflation, and the "rate of change" specification implies inflation depends also on how fast aggregate demand is growing relative to potential (demand growth gap). The estimated coefficient on the cyclical markup is negative while that on the demand growth gap is positive, indicating that inflation falls if the markup is high, and increases if aggregate demand grows faster than potential output. The predictions of the one-year-ahead inflation rate conditional on actual values of the explanatory variables suggested by the Phillips curves track actual inflation well from 1980 to 2003, outperforming those based on a nave model that predicts inflation using only lagged inflation. This result suggests Phillips curves are useful for predicting inflation. The results also indicate that demand growth and output gap variables help most in generating accurate predictions of the inflation rate and trump the markup as the major source of the recent deceleration of inflation.

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