The New Keynesian Phillips Curve and r * ${r}^{* }$

• Published date: 01 September 2024
• Author: Syed Kanwar Abbas
• Date: 01 September 2024
• DOI: http://doi.org/10.1111/1467-8462.12572

The Australian Economic Review, vol. 57, no. 3, pp. 294–301 DOI: 10.1111/1467-8462.12572

The New Keynesian Phillips Curve and

r

*

Syed Kanwar Abbas*

Abstract

In this article, I argue that shifts in the natural

rate of interest provide important insights for

the New Keynesian Phillips Curve (NKPC).

The deviation of the real interest rate from the

natural interest rate (interest rate gap)

captures the monetary policy stance, which

is important for the dynamics of inflation and

the output gap in the wake of persistent and

permanent variation in the natural rate of

interest. I present the evolution of the

estimates of the Taylor‐rule consistent‐nat-

ural interest rate, and thus the associated path

of the expectations of future inflation via the

Fisherian relationship. The path of these two

variables has implications for estimation of

the NKPC.

1. Introduction

In a series of papers, I have taken the New

Keynesian Phillips Curve (NKPC) seriously

as a model of inflation for testing its empirical

plausibility for Australia and other countries.

The NKPC is a behavioural equation that

provides useful ideas about the process of

inflation compared to the family of other

Phillips curves. This includes, inter alia, the

presence of imperfectly competitive markets,

deep structural parameters of price stickiness

based on microeconomic foundations and

useful policy implications related to expected

future inflation, in that anticipated disinflation

brings output boom. For open economies like

Australia, the underlying primitive parameters

also include the degree of openness, which

either captures the changes in domestic output

gap relative to changes in the foreign output

gap (that is, Woodford's 2007 NKPC) or

changes in exchange rate relative to expected

future changes in exchange rate (that is, Gali

and Monacelli's 2005 NKPC).

1

One of the features imbedded in the New

Keynesian model implies that the output gap

(that is, deviation of output from the natural

rate of output) is driven by the interest rate gap

(that is, deviation between the real interest rate

and natural rate of interest). The role of the

natural rate of interest (equilibrium real rate of

interest) denoted by

r*

is widely ignored in the

NKPC. It is also assumed that it is constant

and, thus, the short‐term policy interest rate

and expected future inflation move one‐for‐

one, given the natural interest rate. The natural

rate of interest, however, is not constant; rather

it has declined in developed countries. The

* International Business School Suzhou, Xi'an Jiaotong

Liverpool University, 111 Ren'ai Road, Suzhou, Jiangsu,

China; email <Syed.Abbas@xjtlu.edu.cn>.

© 2024 The University of Melbourne, Melbourne Institute: Applied Economic & Social Research, Faculty of Business

and Economics.

Published by John Wiley & Sons Australia, Ltd