The Phillips Curve and Underlying Inflation

This paper examines methods of controlling the supply shock in the estimation of the Phillips curve and discusses the relationship between the supply shock and inflation inertia. The empirical results clearly show that controlling the supply shock effect, not only for current inflation but also for lagged inflation using the asymmetry of the price change distribution, substantially outperforms the traditional method in terms of the robustness to alternative lag specifications, predictive power, and parameter stability for changes in the estimation period, which are the essential properties for the practical use of the Phillips curve. These results suggest that (1) because supply shocks hit broad sectors, it is not appropriate to restrict the proxy for the supply shock to the relative price changes of a fixed commodity basket; and (2) the inflation inertia corresponds to the underlying inflation from which the supply shock effect has been eliminated.