New Keynesian Phillips Curve and inflation dynamics in Australia

The New Keynesian Phillips Curve (NKPC) was developed as a response to the New Classical critique that Keynesian macroeconomics lacked micro-foundations. The NKPC provides theoretical micro-foundations that attempt to explain, inter alia, nominal rigidities and, explicitly price stickiness. This paper investigates the validity of the NKPC for Australia. In contrast to the findings for the USA and Euro area, we find that neither the output gap nor marginal cost appears to be a key driving force variable across different set of instruments and estimators (GMM and 2SLS) over the sample period from 1959 to 2009. The flattening of the NKPC along with significant presence of price stickiness is also found in the data. In particular, the reduced form coefficients and implied estimates from the structural parameters of the model support the view that inflation dynamics are forward looking while the role of lagged inflation is also statistically important only after 1980s. However, we claim that the forward looking baseline NKPC contrary to the hybrid NKPC is stable and better explains inflation dynamics for the Australian economy.

Research Highlights► Both the marginal cost and output gap do not appear statistically significant driving force variables in the Australian data. ► The economy-wide labour income share and labour income share in the nonfarm sector, as proxies of marginal cost are statistically insignificant in the forward looking and hybrid NKPC. ► Inflation dynamics are forward looking over the period from 1959 to 1982 while both forward and backward looking over the recent period from 1983 to 2009. ► Inflation dynamics are forward looking though the role of lagged inflation has also become statistically important in the hybrid model. ► However, the forward looking baseline NKPC contrary to the hybrid NKPC is stable and better explains inflation dynamics in Australia.