NKPC

Failure of Phillips curve and background:

• Around 1980’s Phillips curve failed as it already had a limitation that are listed as follows:

 Wages and prices are inter-related, as cost of production including wages, impacts the prices of good, while
price of good impacts the cost of living, so the wages are also influenced by changes is price. The Phillips
curve considers the effect of the wages on the prices only, while, ignores the impact of the prices on wages.

 The Phillips curve assumes that inflation is the internal problem of the country and impacts only the
domestic labour market and ignores the fact that inflation in the present times is influenced by the
fluctuations of prices internationally.

 When stagflation occurred in the 1970s, Phillips curve was true in the short-term only as it failed to justify
in scenarios when there was stagflation in the economy, i.e., the position when both unemployment and
inflation were high. So, during the state of stagflationary pressure in the analysis of the Phillips curve does
not hold.
• So this led the world towards establishing a better tool for macroeconomic policy framework, which was NKPC or new
Keynesian Phillips curve, which includes the expected inflationary pressure both forward looking expectation and backward
looking expectation (Motilal Bicchal, 2018), (Olivier Coibion, 2019), so the NKPC curve is basically,

• …………..(1)

• where is current period inflation, is expected inflation about t formed at t-k period, and , is error term.

• So this is the equation of NKPC where in this equation we are not considering the unemployment changes or GDP gap, for
sake of simplification.

• We would set household expectations here where 5000 households analysed in RBI data across 16 cities from Q4:2006 to
Q4:2022 are considered based on the changes observed in CPI index and changes in it. If households are unbiased and utilizes
information available correctly to predict inflation, then expected inflation will be equivalent to the actual inflation which
means =0, and =1, then inflation expectation will be unbiased predictor.

• ……..(2)

• Where the value of k= 1 for representing the one-quarter or 3 month ahead predictions or k= 4 for one year lag (or lead)
expectations.

• If null hypothesis states = 0, that is empirical validation to state the unbiasedness.

Objectives, Methodologies and analysis:
• Now there are two objectives here A.) impact of inflation expectations on actual inflation. B.) components
that influences the household expectations, and understand how these component impact inflation.

• Households observed- 5000, across 16 cities, cpi is also observed along with household expectations, to
compare the results between cpi(actual condition of the prices are reflected through cpi, for sake of
generalizing wpi is not considered) and iesh data(the household data is a combination of monthly, bi-monthly,
quarterly and yearly hence on an average the data is converted to monthly-current expectations, quarterly-
one quarter expectations and yearly-one year expectations are obtained manually).
• Now for the first objective, the descriptive statistics part is observed to analyse mean, median of the
expectations by households in Table:1, in Table:2 has unit root tests, which is used to identify stationarity, it is
fully observed on the basis of CPI inflation as WPI became measure of inflation since 2011-2012, hence to
for sake of simplifying the scale within the analysed variables only CPI Inflation is taken. CPIU(cpi urban),
CPIC(cpi combined), CPIIW(cpi industrial workers), CPIF(cpi food) are the variables here. Here in table-2,
the unit root test, analysis is based on Augmented Dickey Fuller tests and Phillips-perron tests.

• Table:1
  CPIC CPIIW CPIF Currentexp One- One-yearexp
quarterexp

Mean 7.57 8.91 9.1 10.04 10.45 11.12

Median 7.6 9.05 9.8 10.68 10.85 12.21
Maximum 11.34 14.3 22.56 12.9 13.22 14.5

Minimum -2.4 5.35 1.9 4.5 5.3 5.55

Std.dev 4.01 3.22 4.17 2.9 2.88 2.85

Table-2
Variables ADF PP Integration
  Data in levels    
CPIU -1.78 -1.077 I(0)

(0.66) (0.77)
CPIC -1.04 -1.38 I(0)

(0.7) (0.46)
CPIIW -1.108 -0.928 I(0)

(0.56) (0.6)
CPIF -0.78 -0.89 I(0)

(0.5) (0.13)
-2.81 -2.34 I(0)

(0.16) (0.22)
-2.755 -2.28 I(0)

(0.09) (0.08)
-2.09 -1.98 I(0)

(0.077) (0.14)
  Data in first difference    
CPIU -2.78 -6.33 I(1)

(0.06) (0.01)
CPIC -3.38 -6.78 I(1)

(0.01) (0.00)
CPIIW -5.44 -6.11 I(1)

(0.006) (0.00)
CPIF -4.85 -7.08 I(1)

(0.01) (0.00)
-8.22 -9.78 I(1)

(0.00) (0.00)
-9.11 -8.68 I(1)

(0.00) (0.00)
-8.33 -9.75 I(1)

(0.00) (0.00)
• From the previous table we can conclude, data become stationary after first order differences, the next part is
to test the unbiasedness of expectation based on equation (2), using Newey-West method as established in
1987.
• Table:3 Unbiasedness test of inflation expectations of household:
variables ρ-values of t-test biased
Currentexp    
CPIIW 0.52 Yes
CPIF 0.68 Yes
CPIC 0.66 Yes
One-quarterexp    
CPIIW 0.43 Yes
CPIF 0.28 Yes
CPIC 0.44 Yes
One-yearexp    
CPIIW 0.49 Yes
CPIF 0.88 Yes
CPIC 0.35 Yes
• Through this method it can be said that there is biasedness within the variables, and hence the null hypothesis
initially created stating α= 0, and β=1 is basically rejected here.

• Now to get the idea on second objective, the first and foremost thing is to identify the most important factors
that can impact the household expectations, which are basically food and fuel. The components food and fuel
are included within the CPI based on urban economy and industrial worker index.

• Table:4 Correlation between CPIIW and inflation expectation:

          CPIIW            
  t-5 t-4 t-3 t-2 t-1 t t+1 t+2 t+3 t+4 t+5
0.62 0.6 0.75 0.66 0.564 0.517 0.47 0.49 0.55 0.33 0.31

0.59 0.55 0.66 0.591 0.553 0.522 0.46 0.5 0.46 0.44 0.4
• Table:5 Correlation between CPIU and inflation expectation:

          CPIU            

  t-5 t-4 t-3 t-2 t-1 t t+1 t+2 t+3 t+4 t+5

0.6 0.64 0.723 0.78 0.68 0.73 0.61 0.567 0.61 0.2 0.1

0.54 0.57 0.71 0.8 0.77 0.79 0.55 0.567 0.66 0.3 0.2

• These tables above explains that the correlation between household expectation quarterly and yearly with lags
and lead of the expectations, on CPIU and CPIIW.
• Next a regression analysis is obtained where over all expectations with all the CPI indices is observed within
the table below.
• Table:6 Regression analysis
  Currentexp One-quarterexp One-yearexp
       
CPIU(overall) 0.211** 0.216** 0.234**

(0.566) (0.531) (0.67)

CPIIW(overall) 0.036 0.33 0.328

(0.446) (0.088) (0.023)

CPIIW(food overall) 0.318 0.146 0.46

(0.44) (0.007) (0.05)

CPIIW(fruits-veg) 0.33 0.44 0.536

(0.11) (0.191) (0.277)

CPIIW(transport) 0.418 0.72 0.155

(0.09) (0.027) (0.08)

CPIIW(fruits-veg)(t-1) 0.0207 0.011 0.332

(0.003) (0.077) (0.088)

CPIIW(fruits-veg)(t-2) 0.382 0.435 0.231

(0.018) (0.01) (0.55)

CPIIW(transport)(t-1) 0.156 0.443 0.489

(0.001) (0.61) (0.04)

CPIIW(transport)(t-2) 0.337 0.182 0.67

(0.022) (0.005) (0.003)

       
intercepts 8.903** 8.996** 9.019**
  (0.6) (0.423) (0.443)
R2 0.52 0.57 0.65
       
Adjusted R2 0.49 0.55 0.59
       
** means 0.95% CI, p<0.05      
• From the table above we can see that the adjusted R 2 explain 49%, 55% and 59% of the model associated
with Current inflation expectations, quarterly inflation expectation and yearly inflation expectation
respectively.

• As we can observe here that, even though normal regression analysis is quite justified but as this is a panel
data, panel data analysis is best suitable while examining inflation expectations of households because
variations are observed across cities over time. Applying panel data regression, would help model inflation
expectations as a function of not only food and fuel price fluctuations (as captured in CPIU i.e. CPI urban
data), but also a state fixed effect (i.e., state specific factor that does not change over time, or, that captures
fixed differences in inflation expectations across states), a time fixed effect (or a factor common to all states
that changes over time), alongside a random error term. The table below explains about the panel data
analysis.
• Table:7 Panel data Analysis

Variables

Constant 8.68 8.96

(0.632) (0.659)
CPIU(t-1) (Food) 0.32 0.3443
(0.055) (0.108)
CPIU(t-1)(Fuel) 0.077 0.112
(0.0556) (0.004)
observations 700 700
Number of states 16 16
Overall adjusted R2 0.1536 0.312
     
R2 within 0.228 0.2841
Hausman Test 4.886 4.71
(0.106) (0.135)
Effects Random Random
Time Fixed effects No No
State Fixed effects No No
• As there is no fixed effect observed here, and the R2 is also very low, it can be said that the NKPC model is
not much relevant here.
• Conclusion and limitations:

• It can be observed from this entire paper that the NKPC curve is not justified given the overall household
expectation, if the model included forward expectation and backward expectation as well as GDP growth or
unemployment levels amongst the independent variable, the model could have had different results, which
has not been done here due to time constraint. Also for further research long term impacts and short term
impacts of household expectations could be an interesting part.

• Some qualitative variables like expectation based on gender and education levels are also some of the
interesting aspects that can be utilized for further research.
References:

Mehra, Y. (2004). The output gap, expected future inflation, inflation dynamics:another look. Elsevier.
Motilal Bicchal, N. K. (2018). The properties of inflation expectations: Evidence for India. Elsevier, 74-89.
Olivier Coibion, Y. G. (2019). Inflation expectations as a policy tool? EconomiA.