Non-linear Phillips curves reshape euro area monetary policy

The paper develops a New Keynesian model where price and wage Phillips curves exhibit true curvature, moving beyond the quasi-linear structure of standard models.

This framework introduces endogenous adjustment of price and wage setting frequencies, which vary with economic conditions.

Unlike conventional models that attribute inflation dynamics primarily to exogenous supply shocks, this model finds that the impact of shocks is asymmetric and depends on their timing, size, and the business cycle.

Using euro area data from 1999Q1 to 2024Q4, the authors estimate and simulate the non-linear model, analyzing the recent inflation surge.

They find that nominal adjustment reacts nonlinearly to both the sign and size of shocks, intensifying in inflationary states while remaining relatively unresponsive during disinflationary episodes.

The model's Phillips curve slopes and stabilization trade-off are state-dependent, addressing a key shortcoming of the standard New Keynesian model.

This implies that monetary policy is more effective in curbing inflation, and supply shocks have larger effects during periods of high inflation.

The paper makes three main contributions: developing a New Keynesian model with endogenous price and wage adjustment frequencies, proposing a nonlinear estimation strategy using aggregate euro area data, and studying how state-dependent adjustment frequencies shape the inflation-real activity trade-off, particularly during the recent inflation surge.

This framework helps explain how inflation was brought down without a deep recession, a phenomenon difficult to reconcile with conventional linear models.