Does Labor's Share Drive Inflation?

Jeremy Bay Rudd, Karl Whelan
2005 Journal of Money, Credit and Banking  
Publication information Journal of Money, Credit and Banking, 37 (2): 297-312 Publisher Blackwell -published on behalf of The Ohio State University Link to online version A number of researchers have recently argued that the new-Keynesian Phillips curve matches the empirical behavior of inflation well when the labor income share is used as a driving variable, but fits poorly when deterministically detrended output is used. The theoretical motivation for these results rests on the idea that the
more » ... utput gap-the deviation between actual and potential output-is better captured by the labor income share, in tum implying that central banks should raise interest rates in response to increases in this variable. We show that the empirical evidence generally suggests that the labor share version of the new-Keynesian Phillips curve is a very poor model of price inflation. We conclude that there is little reason to view the labor income share as a good measure of the output gap, or as an appropriate variable for incorporation in a monetary policy rule. JEL code: E3I RECENT YEARS have seen an explosion in research aimed at assessing monetary policy rules using macroeconomic models built from explicit microfoundations. In many versions of these models, pricing behavior is described by a "new-Keynesian Phillips curve," which relates inflation to expected future inflation and the output gap JC,: n, = ^E,K,+ i + yxt. (1) Under rational (i.e., model-consistent) expectations, this equation can be re-written as <
doi:10.1353/mcb.2005.0023 fatcat:stmszoxj4rgdvcu6yzs5wowf5e