Expectation horizon and the Phillips curve: The solution to an empirical puzzle

Estimates of the slope of the Phillips curve reported in the literature cover a range from roughly -0.6 to zero depending on specification. Forward-looking specifications, favored by theory, produce the smallest slope estimates. This paper addresses this puzzle by studying the bivariate process of inflation and unemployment in a fairly general unobserved components framework allowing for stochastic trends and related cycles. Analysis reveals that the slope of the implied Phillips curve will depend critically on the horizon of the forward-looking inflation expectation provided the cyclical component of unemployment is highly persistent. Empirical analysis results show that is the case, suggesting that the choice of expectation horizon, generally set at one quarter in the New Keynesian literature, may play an important role in this debate. Copyright (c) 2007 John Wiley & Sons, Ltd.