Book Description

The inflation equation, more commonly known as the Phillips curve, lies at the heart of modern macroeconomic modeling. This Keynesian relationship between inflation and unemployment discovered by Phillips (1958) soon became widely adopted by policymakers in the 1960's. However, its empirical shortcomings led to competing theories such as the natural rate hypothesis by Friedman (1968), who alongside Phelps (1967) and Lucas (1972), condemned its implications of money non neutrality. More recently, the specification has adapted to capture nominal inertia led by the New Keynesian school of Fisher (1977) and Taylor (1980), as an answer to the classical result of neutrality. The Phillips curve remains as a relationship of interest to capture the aggregate behaviour of the supply side in the economy, connecting the labour market and the pricing decisions of firms. This Thesis consists of three self contained works, each of which are set out within their own chapter but connected by the employment of the theoretical framework of this inflation equation. They attempt to answer three specific economic questions related to inflation dynamics and labour market frictions. The first analysis concerns itself with the labour market policy of the working hours restriction; specifically with the question of how this labour market policy affects unemployment in the long run. I find weak evidence of a fall in unemployment shortly after the announcement of this policy. Secondly, whether or not one can capture the different characteristics displayed by the labour markets of the US and EU using labour market frictions in the determination of inflation dynamics. Our findings lead us to the conclusion that it is indeed possible to capture these characteristics when analyzing a Phillips curve specified in terms of unemployment. Lastly the question of whether aggregate prices are better represented by controlling for heterogeneity. The results obtained lead us to infer that controlling for heterogeneity of this kind does indeed affect the dynamics of the macro model and does not wash out in the aggregate.