Estimation of New Keynesian Phillips Curve for Nigeria

The New Keynesian Phillips Curve (NKPC), a fast-evolving model developed, describes the relationship between inflation and unemployment. The model wields several advantages including its development from micro-foundations, the inclusion of future expectations in modeling inflation thus makes monetary policy systematic and its ability to replicate the inflation dynamics found in data. Despite its interesting attributes, result obtained from countries such as the USA, EU countries and South Africa amongst others show that the model has significant setbacks including its somewhat inability to replicate the actual relationship between inflation and economic output, the overstating role of expectations in price setting, and the relative importance of lagged inflation in the model. To test its performance for Nigeria, which is nonexistent, this study is developed. It employs the Hybrid-NKPC for Nigeria using a quarterly dataset from 2000Q1 -2018Q4. The time frame is chosen due to the availability of data. The NKPC model relates current inflation to future expected inflation and the output gap. The H-NKPC is an extension of the basic NKPC model with the inclusion of the lagged inflation in the model, also developed from micro-foundations. In the estimation of H-NKPC, two sets of results are obtained, first using the detrended output and second using marginal cost proxied by share of labor compensation in income. Results are obtained using Generalized Methods of Moments (GMM). In the first case, using detrended output results strongly support the importance of forward-looking factors, the need for the lagged inflation but the output gap is not statistically significant as a driver of inflation. In the second case using marginal costs, similar results are obtained. That is, both future expected and lagged inflation are statistically significant, but with the real variable that is, the marginal cost is statistically insignificant. Thus, the result lends support to H-NKPC which implies that lagged inflation is a significant part of inflation determination in Nigeria. These results suggest the dominant price-setting behavior is forward-looking. Furthermore, neither real marginal costs nor output gap is found statistically significant. As empirical evidence suggests, changes in real economic activities are the relevant determinant of inflation, thus different perspectives on the output gap such as the use of lagged marginal costs or growth rate of marginal costs may suffice.