Improving the Phillips Curve with an Interaction Variable

Improving the Phillips Curve with an Interaction Variable San Fan Fed finds that modifying the Philips Curve with a multiplicative combination of lagged inflation and the lagged output gap better forecasts inflation.

Here’s the abstract:

“A key challenge for monetary policymakers is to predict where inflation is headed. One promising approach involves modifying a typical Phillips curve predictive regression to include an interaction variable, defined as the multiplicative combination of lagged inflation and the lagged output gap. This variable appears better able to capture the true underlying inflationary pressure associated with the output gap itself. Including the interaction variable helps improve the accuracy of Phillips curve inflation forecasts over various sample periods.”

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