European Inflation and the New Keynesian Phillips Curve

[Author Affiliation]Sandeep Mazumder, , , , mazumds@wfu.edu[Acknowledgment]I wish to thank the anonymous referees for their valuable comments and suggestions that helped shape this manuscript.1. IntroductionOn June 1, 1998, the European Central Bank came into being with the goal of maintaining price stability in the euro zone.1 The ability to describe inflation as accurately as possible has long been a key goal that macroeconomists pursue, and in light of the introduction of the euro currency in the late 1990s, this topic is particularly pertinent in Europe. To this end, recent research has devoted a great deal of time to the New Keynesian Phillips Curve (NKPC), a model that examines price setting behavior based on nominal rigidities founded on the work of authors such as Taylor (1980) and Calvo (1983). This model has not been without controversy, but even so it remains a workhorse of macroeconomics, perhaps attributable to the lack of a better alternative.In particular, the model is thought to have first seen genuine empirical success when Gali and Gertler (1999) estimated the NKPC using U.S. data and found that the model describes changes in U.S. prices considerably well. Indeed, Gali, Gertler, and Lopez-Salido (2001) conduct a similar exercise using European inflation data and find that the NKPC is even more applicable to the euro area than for the United States over the period from the 1970s to the latter 1990s. One of the key innovations of these articles is that the labor income share (equivalently, real unit labor costs) is used as the proxy for real marginal cost in the NKPC as opposed to previously used proxies, such as detrended real output. Following in the same vein as Gali, Gertler, and Lopez-Salido (2001), others have also found that the NKPC can be accurately used to describe inflation in Europe. For example, Rumler (2007) estimates the labor share NKPC for nine euro area countries and finds evidence in favor of the model, while Jondeau and Bihan (2005) argue that the labor share NKPC may describe European inflation dynamics well, depending on the number of leads or lags that one is willing to include into the model. Similarly, Leith and Malley (2005) use the NKPC to find greater evidence of price stickiness in Europe as compared to the United States, where the proxy for real marginal cost is labor's share of income.While some authors have questioned the empirical performance of the NKPC in Europe when using different econometric techniques (such as Bardsen, Jansen, and Nymoen 2004; Paloviita 2005; Lawless and Whelan 2007; Boug, Cappelen, and Swensen 2010), a more obvious problem remains with the approach of Gali, Gertler, and Lopez-Salido (2001) to estimating the NKPC for Europe that has not received much attention in the literature. That is, the labor income share cannot be used to proxy for real marginal cost in the NKPC if we are to address the cyclicality of real marginal cost in a manner in keeping with predictions from basic microeconomic theory. Namely, we believe that marginal cost is likely to be procyclical over the business cycle, whereas the labor income share in fact moves countercyclically. Furthermore, the labor share proxy of real marginal cost is founded on the assumption that labor input can be freely adjusted at a fixed real wage rate. The problem with this assumption is that it ignores the notion of labor adjustment costs, which is something that cannot reasonably be discounted. Specifically, one can think of labor as being the product of the number of workers in an economy and the respective number of hours that they work. Seminal work by Oi (1962) has argued that employment is not perfectly flexible in the short run, something that the derivation of the labor share marginal cost proxy does not take into account.This article reconsiders the derivation of a proxy for real marginal cost in a similar manner to that done in Gali and Gertler (1999) and Gali, Gertler, and Lopez-Salido (2001), with the crucial difference that we account for the existence of labor adjustment costs. …