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Phillips
Curve
Specification
And
the
Decline
in
U.
S.
Output
and
Inflation
Volatility
*
Robert
J.
Gordon
Northwestern
University
and
NBER
First
Draft
to
be
Presented
at
Symposium
on
The
Phillips
Curve
and
the
Natural
Rate
of
Unemployment,
Institut
für
Welwirtschaft
Kiel,
Germany
June
3
‐
4,
2007
____________________
*I
am
grateful
to
Rob
McMenamin
for
excellent
research
assistance
on
this
paper
and
to
Ian
Dew
‐
Becker
for
his
insights
and
assistance
on
previous
related
papers.
Phillips
Curve
Specification
And
the
Decline
in
U.
S.
Output
and
Inflation
Volatility
ABSTRACT
Journalists
have
recently
characterized
the
Fed’s
view
that
the
slope
of
the
United
States
Phillips
Curve
(PC)
has
become
substantially
flatter,
by
a
factor
of
at
least
half,
since
the
mid
‐
1980s.
The
flattening
of
the
Phillips
curve
is
documented
in
a
particular
style
of
PC
research
based
on
the
New
Keynesian
Phillips
Curve
(NKPC)
literature,
in
which
PC
specifications
involve
links
between
the
current
inflation
rate
and
short
lags
on
inflation,
and
on
the
current
unemployment
rate.
The
first
part
of
this
paper
uses
a
wide
variety
of
statistical
tests
to
show
that
the
Fed’s
PC
equation,
as
based
on
research
by
Roberts
(2006),
is
strongly
rejected
both
by
traditional
and
nontraditional
tests
when
compared
to
the
Gordon
“triangle”
model
that
was
developed
in
the
early
1980s.
The
Roberts
version
of
the
NKPC
is
entirely
nested
in
the
triangle
model,
allowing
each
of
its
exclusion
restrictions
to
be
tested,
and
each
is
rejected
at
high
levels
of
statistical
significance.
The
remainder
of
the
paper
asks
why
the
volatility
of
inflation,
of
output
changes
and
of
the
output
gap
has
declined
substantially
after
1984,
a
finding
on
which
U.
S.
macroeconomists
share
an
unusual
consensus.
Our
analysis
based
on
a
small
macroeconometric
model
concludes
that
about
1/3
of
the
reduction
in
the
volatility
of
real
GDP
can
be
traced
to
the
role
of
supply
shocks
in
the
triangle
inflation
equation.
More
important
are
errors
in
the
output
gap
or
“IS”
equation
that
quantifies
the
role
of
monetary
policy
in
reducing
output
when
interest
rates
are
high
and
stimulating
output
when
interest
rates
are
low.
To
highlight
the
role
of
Phillips
curve
specifications
in
the
analysis
of
reduced
U.S.
business
cycle
volatility,
we
show
that
the
Roberts/NKPC
type
Phillips
curve
specification
misses
much
of
the
role
of
supply
shocks
in
contributing
to
reduced
volatility
in
both
inflation
and
output.
Finally,
we
find
no
role
at
all
for
monetary
policy
in
reducing
the
volatility
of
inflation
or
output,
unless
monetary
policy
is
more
broadly
defined
to
include
the
component
of
“IS
stabilization”
represented
by
the
financial
deregulation
of
the
late
1970s
that
reduced
the
volatility
of
residential
construction.
Robert
J.
Gordon
Department
of
Economics
Northwestern
University
Evanston
IL
60208
‐
2600
rjg@northwestern.edu
http://faculty
‐
web.at.northwestern.edu/economics/gordon
Phillips Curve Specification and Business Cycle Volatility, Page
1
I.
Introduction
Has
the
slope
of
the
American
Phillips
Curve
(PC)
become
flatter
in
the
past
two
decades?
Recently
the
Wall
Street
Journal
announced
on
its
front
page
the
finding
of
recent
research
at
the
Federal
Reserve
Board
demonstrating
a
sharp
flattening
of
the
PC
since
the
mid
‐
1980s.
The
primary
Fed
study
by
Roberts
(2006)
attributes
to
monetary
policy
both
the
change
in
slope
and
the
related
marked
reduction
in
U.
S.
business
cycle
volatility.
The
channel
of
monetary
policy
influence
comes
from
an
increased
Fed
responsiveness
to
output
and
inflation,
so
that
any
pressure
for
higher
inflation
or
any
movement
of
the
output
gap
away
from
zero
are
“nipped
in
the
bud”.
A
flatter
PC
directly
contributes
to
the
interplay
between
monetary
policy
and
output
stabilization,
as
movements
of
the
output
gap
above
zero
generate
less
inflation
than
formerly,
requiring
less
monetary
tightening
and
thus
a
smaller
subsequent
downward
adjustment
in
output.
However,
both
of
these
two
conclusions
are
highly
controversial.
The
verdict
that
the
PC
slope
has
flattened
is
highly
sensitive
to
specification
choices,
and
a
primary
purpose
of
this
paper
is
to
examine
the
interplay
between
model
specification
and
conclusions
about
the
stability
of
PC
parameters.
Further,
while
all
research
agrees
that
output
has
become
less
volatile
since
the
mid
‐
1980s,
much
of
it
contradicts
Robert’s
conclusion
that
the
improved
conduct
of
monetary
policy
is
responsible.
Stock
and
Watson
(2002,
2003)
were
among
the
first
to
quantify
the
role
of
smaller
shocks
in
contributing
to
improved
stability,
and
Gordon
(2005)
1.
Also
representing
the
Fed
view
are
Kohn
(2005)
and
Williams
(2006).
of 00
US Federal Reserve: gorden
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