Inflation Dynamics and the New Keynesian Phillips Curve

Keith Sill

Senior Vice President of Research and Director of the Real-Time Data Research Center

Q1 2011

Business Review — A 1977 amendment to the Federal Reserve Act states that the Fed’s mandate is “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Moderate long-term interest rates require low and stable inflation.

Monetary policymakers use instruments such as a short-term interest rate to guide the economy with the aim of achieving an inflation objective. To help guide their decisions, monetary policymakers benefit from having a reliable theory of how inflation is determined, one that relates the setting of their instrument to the unexpected events that hit the economy and consequently to the rate of inflation and other economic variables. In this article, Keith Sill examines a prominent theory of how inflation is determined, as articulated in what is called the New Keynesian Phillips curve. He also investigates some of the implications of the theory for the conduct of monetary policy.

This article appeared in the First Quarter 2011 edition of Business Review.

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