This paper owes a great deal to Doug Laxton. We also thank Phil Lowe, Glenn Stevens and participants in a seminar at the Reserve Bank of Australia for helpful comments. The views expressed in this paper are those of the authors and not necessarily those of the Reserve Bank of Australia. Use of any results from this paper should clearly attribute the work to the authors and not to the Reserve Bank The Phillips curve has generally been estimated in a linear framework. This paper investigates the possibility that the Phillips curve is indeed a curve, and shows that a convex short-run Phillips curve may be a more accurate representation of reality than the traditionally used linear specification. The paper also discusses the policy implications of convexity in the Phillips curve. These include the need for policy to be forward-looking and to act pre-emptively. Convexity provides a strong rationale for stabilisation policy, and it reinforces the need for policy-makers to proceed cautiously. It also implies that deep recessions may have only a marginally greater disinflationary impact than shallower ones,

Monetary policy is typically undertaken with an eye to achieving a select few objectives in the long run. In the United States, the Federal Reserve conducts monetary policy to promote two long-run goals: price stability and sustainable economic growth. In many other countries, central banks have a single long-run goal defined in terms of an inflation target. Yet while central banks have narrowly defined long-run goals, most monitor a wide range of economic indicators. Why do central banks collect and analyze so many indicators? To understand the answer, it is first important to recognize that monetary policy affects economic activity and inflation with long and variable lags. One consequence of the lagged response is that central banks cannot undertake policy actions to immediately realize their inflation or output goals. A second consequence is that the magnitudes of economic responses to policy actions cannot be estimated with precision. Thus,

for her excellent research assistance. The performance of the U.S. economy in the late 1990s was very good by most measures. Overall growth was robust; and both the unemployment rate and inflation were at the lowest levels in over 30 years. But for many economists, delight in the economy’s strong performance was tempered by puzzlement, even consternation. Since the 1960s, unemployment rates below 6 percent or so had been associated with rising rates of inflation. Yet in the late 1990s, with unemployment rates around 4 percent, inflation declined. Explanations for the breakdown in the historic link between inflation and unemployment tend to fall into two categories: 1 The U.S. economy has been the beneficiary of a number of temporary factors that have held down the inflation rate; and The U.S. economy has entered a new era of intense competition and high productivity growth in which inflation is much less of a threat.