Mind the Output Gap: The Disconnect of Growth and Inflation During Recessions and Convex Phillips Curves in the Euro Area

59 Pages Posted: 3 Feb 2017

See all articles by Marco Gross

Marco Gross

International Monetary Fund (IMF); European Central Bank (ECB)

Willi Semmler

The New School - Department of Economics; Universitaet Bielefeld; IIASA

Multiple version iconThere are 2 versions of this paper

Date Written: January 25, 2017


We develop a theoretical model that features a business cycle-dependent relation between output, price inflation and inflation expectations, augmenting the model by Svensson (1997) with a nonlinear Phillips curve that reflects the rationale underlying the capacity constraint theory (Macklem (1997)). The theoretical model motivates our empirical assessment for the euro area, based on a regime-switching Phillips curve and a regime-switching monetary structural VAR, employing different filter-based, semi-structural model-based and Bayesian factor model-implied output gaps. The analysis confirms the presence of a pronounced convex relationship between inflation and the output gap, meaning that the co-efficient in the Phillips curve on the output gap recurringly increases during times of expansion and abates during recessions. The regime switching VAR reveals the business cycle dependence of macroeconomic responses to monetary policy shocks: Expansionary monetary policy induces less pressure on inflation at times of weak as opposed to strong growth; thereby rationalizing relatively stronger expansionary policy, including unconventional volume-based policy such as the Expanded Asset Purchase Programme (EAPP) of the ECB, during times of deep recession.

Keywords: Phillips curve, nonlinearity, monetary VAR, inflation targeting, monetary policy, euro area

JEL Classification: E31, E42, E52, E58

Suggested Citation

Gross, Marco and Semmler, Willi, Mind the Output Gap: The Disconnect of Growth and Inflation During Recessions and Convex Phillips Curves in the Euro Area (January 25, 2017). ECB Working Paper No. 2004, Available at SSRN: https://ssrn.com/abstract=2910934

Marco Gross (Contact Author)

International Monetary Fund (IMF) ( email )

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European Central Bank (ECB) ( email )

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Willi Semmler

The New School - Department of Economics ( email )

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New York, NY 10003
United States

HOME PAGE: http://www.newschool.edu/nssr/faculty/?id=4e54-6b79-4e41-3d3d

Universitaet Bielefeld ( email )

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IIASA ( email )

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