The path of output prior to the financial and economic crisis turned out to be not sustainable and lower than previously estimated in some European crisis countries. Specifically, the output gaps have been underestimated (and inversely potential output overestimated) before the recent crisis. It is fair to say that the employed estimation techniques failed to provide valid real-time assessments of the state of the credit boom driven euro area economies. One reason for this may be the breakdown of the Phillips curve relationship during the last years. Against this backdrop, we comprehensively analyse the validity of the Phillips curve for five European countries with a focus on the recent crisis. We find that a mostly insignificant relation between inflation and the output gap or unemployment gap, which questions the adequacy of the Phillips curve to identify the sustainable level of output in an economy. The credit-driven boom in crisis countries has made clear that (disadvantageous) financial markets conditions may result in structural and long-term real economic distortions that are not yet taken into account in conventional methods for the estimation of potential output and the output gap. Since both, potential output and output gaps, are a key notion in policymaking, incorporating financial factors could improve the reliability of the estimates. Our results point in this direction.
Schleer, Frauke and Marcus Kappler (2014), The Phillips Curve: (In)stability, the Role of Credit, and Implications for Potential Output Measurement, ZEW Discussion Paper No. 14-067, Mannheim. Download