An assessment of the new Keynesian Phillips curve in the Korean economy

Abstract

This paper examines the validity of the new Keynesian Phillips curve in the Korean economy, which is characterized by its high dependence on foreign materials as intermediate inputs. A new Keynesian Phillips curve in an open economy is necessary for this purpose, and the attempt is based on the distinction between gross and value-added prices. It is shown that a standard new Keynesian Phillips curve can be interpreted as describing the behavior of gross price inflation and, therefore, it is essential to incorporate intermediate input costs in constructing marginal cost measures. Moreover, from this gross price inflation model, the valuedadded price inflation model is derived explicitly, yielding testable equations for the new Keynesian price-setting. This paper's approach offers an integrated framework to analyse three driving forces of inflation: labor cost, a change in market structure and the movement of the relative price of imported materials. Finally, estimation results show that (1) the new Keynesian Phillips curve can be supported in the Korean economy especially for the period since the early 1980s; (2) backwardlooking behavior plays only a minor role in describing inflation dynamics for the economy as a whole; (3) there is partial evidence that the Phillips curve became flatter over time. However, considering large uncertainty surrounding the parameter estimates, further research is necessary to address this issue.