The Philips Curve in Europe – A Zeon’s paradox approach

This paper aims to investigate the Phillips curve on a regional level in Europe. For this purpose, I fully follow the strategy of Fitzgerald and Nicolini (2014) and inspect the negative relationship between unemployment rate and future inflation in Austrian and German provinces. I collected a novel data set by combining inflation data provided by Beck, Hubrich, and Marcellino (2009) with regional unemployment data. Heart of this paper is to explore the connection between unemployment rate and inflation rate. However, both variables are affected by monetary policies. The European Central Bank (ECB), in our case, sets the interest rate to ensure price stability. By doing so the ECB influences both unemployment rate and future inflation. That both variables are linked not only through their relationship but also through monetary policies is called an endogeneity problem. Thus, the relationship between unemployment rate and inflation rate could further be explained via a model through monetary policies, which distorts my research. This triangle of reciprocal interaction between unemployment rate, inflation rate and monetary policies needs to be dissolved to discover the true effect between only unemployment rate and inflation rate. To overcome this problem and detangle the triangle, only leaving the relationship between unemployment rate and inflation rate, I am using regional European data and follow Fitzgerald and Nicolini (2014) approach. Since monetary policies only focus on stabilizing average inflation, just like the European Central Bank only focuses to stabilize inflation in the whole European currency area, I can use local disturbances in each region to investigate the relationship between unemployment rate and future inflation rate. I isolate the connection of interest between unemployment rate and inflation rate by subtracting the average inflation rate and unemployment rate from the regional inflation rate and the regional unemployment rate. The difference leaves me solely with the local relationship between only unemployment rate and inflation rate and cuts of the tip of the triangle (monetary policies) from both unemployment rate and future inflation rate. The essence of this paper is to use those local independent, exogenous shocks to discover a possible structural and robust relationship between unemployment rate and future inflation rate. I refer to this method of using regional shocks as the ‘Zeno’s paradox approach’. Based on the assumption that the NAIRU model is true, I find in line with previous research of regional American data that a 1 percent point increase in the unemployment rate is related with a roughly 0.15 -0.4 percentage point decline in Inflation over the following year. However, due to ambiguous results in my analysis, I caution that my findings do not provide conclusive evidence of a stable Philips curve.