An Econometric Analysis of the Short Run Philips Curve Essay Example

2 providing background information and theory, section 3 introducing the simple adaptive model, and the following section refining the expectation augmented Phillips curve using rational expectations. Finally, in the last section, oil price shocks are used as instrumental variables to measure the inverse Phillips curve – a negative correlation between inflation and unemployment rate. This concept was first observed by Phillips in his study on UK data from 1861-1957 which revealed a negative relationship between unemployment and wage inflation. Subsequent research also identified a similar link between unemployment and price inflation. Initially referred to as the Phillips curve, this theory had strong empirical support showing a stable trade-off between inflation and unemployment. However, in the early 1970s, there were empirical failures when both inflation and unemployment increased simultaneously due to oil price shocks. These critiques led to the development of the expectation-augmented Phillips curve which states that reducing unemployment below its natural rate permanently is only possible if people's expectations are highly irrational.The "new Phillips curve" has sparked renewed interest as there is significant theoretical work suggesting a non-linear relationship between inflation and unemployment. However, various theories propose different non-linear relationships, making the exact shape of this nonlinearity uncertain. The data used in this study are quarterly data that have been seasonally adjusted and span from the year Errol 4 Nine Notation measure uses. These data measure the annual changes in inflation expectations, which are calculated as a measure of expected inflation over the next year at a certain time period.