Title: Mind the output gap: The disconnect of growth and inflation during recessions \& convex Phillips curves in the Euro area
Authors: Marco Gross - European Central Bank (Germany) [presenting]
Willi Semmler - New School for Social Research (United States)
Abstract: A theoretical model is developed that features a business cycle-dependent relation between output, price inflation and inflation expectations, augmenting a previous model with a nonlinear Phillips curve that reflects the rationale underlying the capacity constraint theory. The theoretical model motivates our empirical assessment for the euro area, based on a regime-switching Phillips curve and a regime-switching monetary structural VAR, employing different filter-based, semi-structural model-based and Bayesian factor model-implied output gaps. The analysis confirms the presence of a pronounced convex relationship between inflation and the output gap, meaning that the coefficient in the Phillips curve on the output gap recurringly increases during times of expansion and abates during recessions. The regime switching VAR reveals the business cycle dependence of macroeconomic responses to monetary policy shocks: Expansionary policy induces less pressure on inflation at times of weak as opposed to strong growth; thereby rationalizing relatively stronger expansionary policy, including unconventional volume-based policy such as the Expanded Asset Purchase Programme (EAPP) of the ECB, during times of deep recession.