This paper follows BMR (1988) study and examines the variations in the output-inflation tradeoff by discriminating between the two theoretical frameworks – the New Keynesian nominal rigidity hypothesis and the alternative new classical imperfect information hypothesis. The distinction between these two competing theories has important policy implications. The former suggests that the tradeoff arising from nominal rigidities is a fairly stable economic relationship and it thus can be explored by policy makers, while the latter predicts that the tradeoff due to misperception is not stable and policy makers cannot explore this relationship. This paper conducts a series of tests and finds that a higher degree of nominal rigidity22 leads to a higher output-inflation tradeoff. This
relationship is not only a cross-country observation but also an over-time observation.
Methodologically, this paper summarizes and evaluates different estimation approaches that have been applied in the literature to examine the New Keynesian hypothesis. Namely, they are a baseline two-stage BMR cross-country comparison and three approaches that allow the tradeoff to change over time and examine those changes. A time-variant tradeoff is more consistent with what the theory predicts as trend inflation is far from constant over time. For an over-time analysis, the one- stage approach (see Defina 1991) is preferred, as it avoids a potential efficiency loss arising from a two-stage procedure.
Qualitatively, the cross-country comparison based on the extended sample suggests that the New Keynesian theory is still relevant today. In high-inflation countries, the output-inflation tradeoff that policy-makers face is smaller. However, in each individual country, the output-inflation tradeoff is not constant over time. During a high-inflation period, prices are less rigid. It leads to decreasing effectiveness of demand policy. Policy makers thus need to take a dynamic view towards the tradeoff.
22 In this paper, I focus mainly on nominal price rigidity. Certainly, rigidities arise also from sticky wages or other forms
of nominal frictions (see Christiano, Eichenbaum, and Evans 1997; Rotemberg 1984). The species of rigidities are, nevertheless, relatively unimportant for the discussion of the real impacts of nominal disturbances, as the conclusion would not be altered so long as the degree of these rigidities is inflation-dependent.
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