A New Keynesian Phillips curve estimation for a small open economy in the presence of structural changes: empirical evidence from Turkey

Abstract

This study aims to model inflation dynamics by presenting the evidence supporting instability of the Phillips curve for the period covering the explicit inflation targeting (IT) adoption in Turkey as a small open economy. To this end, Bai and Perron approach is applied to capture possible breaks or instability associated with the structural changes in the hybrid New Keynesian Phillips curve (NKPC) estimation, using quarterly data from 2006:q1 to 2023:q4. The empirical findings reveal that the hybrid model of the NKPC with the control variables gives unstable parameter estimations with significant structural breaks which can be related to some structural changes the Turkish economy experienced for post IT periods. The results also put forward that the inflation-output gap relationship produces larger amount of parameter in high inflation period implying that the Phillips curve steepens with changing price setting behaviour and the effects of reel exchange rate and oil prices on domestic inflation rate. Based on these findings, the weaker anchored expectations may increase the output cost because of the changing trade-off between inflation and output gap. The Central Bank of the Republic of Turkey (CBRT) should take its unstable structure into account in the inflation targeting process.