Real wages, real interest rates and the Phillips Curve: Evidence from Canadian data

This article argues that any analysis of the Phillips Curve without the inclusion of real interest rate may generate a misleading result as any changes in the interest rate impacts the labor capital input mix in the production process, leading to a change in the level of employment in the economy. We justify this argument by developing an empirical model which includes the real interest rate as one of the explanatory variables in addition to inflation and real wages. The model is estimated using the annual data from Canada for the period 1960 to 2004. The estimated result indicates that interest rate variable is indeed significant in explaining the Phillips Curve. A likelihood ratio test conducted suggests that exclusion of real interest rate leads to a misspecification (omitted variable) problem.