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

32 Pages Posted: 2 Jun 2020

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

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Date Written: August 2019


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, 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 convex relationship between inflation and the output gap, meaning that the coefficient in the Phillips curve on the output gap recurringly increases during times of expansion and abates during recessions. Sign‐restricted monetary policy shocks based on a regime‐switching monetary SVAR reveal that 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, during times of deep recession. A further augmented model shows that an effective euro exchange rate shock, too, implies business cycle state‐dependent responses, with more upward pressure on prices arising from unexpected currency depreciation at times of expansion than during recession phases.

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 (August 2019). Oxford Bulletin of Economics and Statistics, Vol. 81, Issue 4, pp. 817-848, 2019, Available at SSRN: https://ssrn.com/abstract=3615208 or http://dx.doi.org/10.1111/obes.12291

Marco Gross (Contact Author)

International Monetary Fund (IMF) ( email )

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Willi Semmler

The New School - Department of Economics ( email )

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Universitaet Bielefeld ( email )

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Bielefeld, NRW

IIASA ( email )

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Laxenburg/Austria, A-2361

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