Expectations, unemployment and inflation: An empirical investigation

Abstract

This paper analyses the empirical relation between inflation and unemployment over the past 25 years by using a panel state-space model. After controlling for the global factor, I find that the domestic rate of unemployment explains 11 percent in the variation of headline inflation, suggesting a significant power that domestic slack has in influencing medium-term core inflation. The global factor, in turn, is well explained by global oil and food prices as well as global trade integration. The contribution of the global slack in explaining the global component of inflation is negligible. Additionally, using a set of threshold regressions, I identify break points that split inflation dynamics into various regimes. In particular, I find a higher sensitivity of inflation to unemployment in high-inflation and/or low unemployment regimes. This finding is consistent with less frequent price adjustments of firms in low-inflation and high-unemployment environments.