An empirical analysis of the Phillips Curve : A time series exploration of Germany

Abstract: The purpose of the paper is to explore the relationship between inflation and unemployment in Germany during the period from 1970 to 2012. Through the methods of cointegration, dynamic OLS and an error correction model, this paper highlights that there is no short run negative relationship between inflation and unemployment, and consequently the short run Phillips curve is an unsuitable instrument for making political decisions. Furthermore, there is a long run relationship between inflation and unemployment, which can be explained with asymmetric nominal wage rigidities and resulting frictional growth. Resulting policy implications reflect the advantage of a permanent higher inflation target for Germany. Since the beginning of the European Monetary Union, Germany has been on average 0.5% under the permanent inflation target of the central bank. Therefore, by using fiscal policy, Germany can reduce permanent unemployment without missing the inflation target of the central bank. Finally, despite of variety of intensive changes in the macroeconomic situation and particularly through the establishment of the European Monetary Union, the CUSUM and CUSUMsq test reveal that the estimate holds validity over the entire observation period and has not changed since the beginning of the European Monetary Union.