At what cost price stability? New Evidence about the Phillips Curve in Europe and the United States. CEPS Working Document No. 302/September 2008.

Andrea, Beccarini and Daniel, Gros (2008) At what cost price stability? New Evidence about the Phillips Curve in Europe and the United States. CEPS Working Document No. 302/September 2008. [Working Paper]

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Abstract

With inflation increasing all over the world, central banks have to consider with some care how quickly to re-establish price stability. A key issue in this context is the short-run cost in terms of foregone output and higher unemployment. In other words, our aim in this paper was to find the ‘sacrifice ratio’ for the Euro Area and for the United States. Our main findings are: The cost of reducing inflation is in most cases higher in the US than in the EA. For example, reducing (headline) inflation by 1% point requires a decline of output of 1.4% in the EU, but 2.3% for the US. Considering core inflation, the sacrifice ratio in terms of output is somewhat higher for the Euro Area (around 4) compared to 3.2 for the US. However, the sacrifice ratios in terms of unemployment are always much larger for the US. Reducing headline inflation by 1% requires an increase in unemployment of little more than 1% in the EA, compared to 8% in the US. However, there is also a long-run ‘hysterisis’ cost that is specific to the Euro Area since the reaction of unemployment to output depends on the state of the economy. During downturns this relationship worsens. This implies that a recession engineered to combat inflation will have an additional cost in terms of lower unemployment later, even after the recovery of the economy.

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