## 5/25/11

### The Phillips curve in Germany

In the posts on the USA and the UK, we mentioned the anti-Phillips curve in which unemployment lags behind inflation by several years. This contradicts the paradigm of the modern economic theory. There are cases, however, which comply with the theory. The Phillips curve in Germany is a good example where unemployment leads inflation by one year.
Figure 1 displays the observed rate of unemployment, u, and that predicted from inflation, which is represented by the GDP deflator, DGDP, according to the following relationship:
u(t-1) = -1.30[0.1]DGDP(t) + 0.105[0.005]              (1)
where u leads by one year. Standard deviation of the residual error is (s=) 0.013 for the period between 1971 (start of DGDP time series) and 2010. Both coefficients in (1) are reliable, and thus, there exists a linear and lagged relation between unemployment and inflation in Germany.

Figure 1. Unemployment and DGDP (both reported by the OECD) in Germany between 1971 and 2010. The lower panel shows the cumulative curves for the annual readings in the upper panel.
Both coefficients in (1) are determined from the cumulative curves with a higher accuracy when provided by linear regression. Figure 2 depicts the Phillips curve in a standard way. The slope of -0.645 instead of the linear coefficient -1.30 in (1) is highly underestimated due to the uncertainty in both time series. At the same time, the determination coefficient R2=0.83 is a strong evidence in favour of the Phillips curve in Germany.
The existence of a conventional Phillips curve in Germany raises a question about the consistency of monetary policy of the Bundesbank. Does the bank conduct a monetary policy, which balances inflation and unemployment? Affirmative answer is counter-intuitive as in the past twenty five years show the unwillingness of the bank to reduce unemployment in exchange for higher inflation.

Figure 2. The Phillips curve for Germany. The unemployment readings are shifted by one year ahead to synchronize with the GDP deflator estimates.