Causes of Failure of the Phillips Curve: Does Tranquillity of Economic Environment Matter?

TL;DR

This paper investigates the variability of the Phillips curve across countries and time, emphasizing that economic tranquility significantly influences its validity, with the relationship weakening or collapsing during recessionary periods.

Contribution

It provides a comprehensive analysis of the Phillips curve's stability across 41 countries from 1980 to 2016, highlighting the role of economic environment tranquility in its validity.

Findings

Phillips relationship holds mainly in developed countries during tranquil periods.

The relationship fails in emerging/frontier economies during tranquil times.

The Phillips curve collapses during recessionary periods, with inflation sensitivity increasing.

Abstract

Although empirical literature regarding the Phillips curve is sizeable enough, there is still no wide consensus on its validity and stability. The literature shows that the Phillips relationship is fragile and varies across countries and time periods; a statistical relationship that appears strong during one decade (country) may be weak the next (other). This variability might have some grounds for idiosyncrasy of a country and its economic environment. To address it, this paper scrutinizes the Phillips relationship over 41 countries over the period 1980-2016, paying attention to how inflation dynamics behave during tranquil and recessionary periods. As a result, the paper confirms the variability of the Phillips relationship across countries, as well as time periods. It documents that the relationship holds in the majority of developed countries, while it fails to hold in emerging and frontier economies during tranquil periods. On the other hand, the relationship totally collapses during recessionary periods, even in developed markets. This shows that tranquillity of economic environment is significantly important for the Phillip trade-off to work smoothly. Moreover, both backward- and forward-looking fractions of inflation remarkably increase during recessionary periods as a result of the Phillips coefficient loses its significance within the model. This indicates that markets become more inflation-sensitive during these periods.