Giulia Gitti (Brown University)

Nonlinearities in the Regional Phillips Curve with Labor Market Tightness

Abstract. This paper is the first to show the presence of nonlinearities in the regional U.S. New Keynesian Phillips curve with labor market tightness as a proxy for economic activity. Such nonlinearities contribute to explaining the unexpected and persistent post-COVID inflation surge and have important implications for monetary policy. The New Keynesian Phillips curve is a structural equation that describes inflation dynamics. It captures the concept that in demand-driven booms, workers ask for higher wages, leading firms to raise prices. Labor market tightness represents labor demand relative to labor supply and is a realistic approximation of labor costs. To guide my empirical exercise, I introduce wage rigidities and search-and-matching frictions in the labor market into a standard multi-sector, two-region New Keynesian model. The model delivers a piecewise log-linear regional Phillips curve, which becomes steeper when labor markets become sufficiently tight. I estimate the Phillips curve using panel variation in core inflation and a newly imputed measure of labor market tightness across U.S. metropolitan areas from December 2000 to April 2023. I instrument labor market tightness with a shift-share instrumental variable to take care of regional supply shocks. The regional Phillips curve has a positive slope that increases almost three times when labor market tightness exceeds the metropolitan area-specific average. This result suggests that if the monetary authority assumes that the Phillips curve is linear, it will risk underestimating inflationary pressures when labor markets run hot, allowing inflation to rise more than expected.