A Factor-Augmented New Keynesian Phillips Curve for the European Union Countries

AbstractIn this paper, a factor‐augmented version of the New Keynesian Phillips curve (NKPC) is assessed using a data set comprised of a large panel of European Union (EU) member countries. The factor‐augmentation is natural given that country‐level inflation rates are highly co‐moving. The presence of unattended common factors is important because it raises the issue of omitted variables bias, as the real marginal cost, which is a regressor of the NKPC, is likely to load on the same factors as inflation. One possibility here is to employ the regular instrumental variables approach. However, if the external instruments load on the same factors as the error term of the NKPC, the instruments would be invalid and the results would therefore likely be misleading. Motivated by this last observation, the present paper proposes a new estimator of the NKPC that allows for very general forms of factor dependencies and endogeneity. Our results provide evidence in support of the NKPC, but only after the presence of common factors has been appropriately accounted for.