The Phillips curve embodies the relationship between measures of inflation and economic activity. This correlation has declined over time in New Zealand and other developed economies, a phenomenon commonly known as the flattening of the Phillips curve.
This paper provides a framework to think about the potential causes of the waning correlation between inflation and activity in New Zealand. Does this declining correlation imply that prices have become less volatile due to price-setting by firms becoming less sensitive to demand pressures? Has demand become less volatile due to households becoming less responsive to the interest rate? Have the random disturbances influencing aggregate supply and demand changed?
We first run computational experiments in a simple model of demand and supply to demonstrate how the declining correlations observed in the data can be generated by two causal mechanisms: changes in the behaviour of economic actors or changes in the composition of random business cycle disturbances hitting the economy. The key message of the experiment is that if disturbances influencing the supply side of the economy are more potent than those affecting the demand side, the correlation between inflation and activity can diminish.
In the next step, we estimate an extended version of the model on New Zealand data to point out potential reasons for the flattening of the Phillips curve over the inflation targeting era. Our methodology does not isolate any particular feature as a single dominant driver of the diminishing correlations observed in the data. Instead, we identify a number of potential mechanisms that contribute to the flattening of the Phillips curve. Our results suggest that changes in the structure of the economy have been fairly mild. However, business cycle disturbances on the supply side have been become much more variable than those influencing the demand side. These supply-side disturbances are very influential in driving the waning correlation between inflation and activity.