Revisiting the Effects of Long-Term Unemployment on Inflation : The Role of Non-Linearities

Does unemployment duration matter for the measurement of economic slack and inflationary pressure? Using an empirical Phillips curve specification that is augmented to feature unemployment duration, we demonstrate that it is necessary to control for state-dependence in the Phillips curve in order to appropriately identify separate slope coefficients for short- and long-term unemployment rates. Whereas several existing studies have concluded that long-term unemployment is immaterial for price pressures, we present new evidence, based on a combination of recent empirical methods, which suggests that the effect of long-term unemployment on inflation is highly state-dependent. In particular, we find that short- and long-term unemployment have similar effects on inflation when the economy is slack in recessions. However, reductions in long-term unemployment are found to be significantly more inflationary than short-term unemployment when aggregate unemployment is low. These findings imply that models of inflation dynamics can be improved by incorporating information about the duration distribution of unemployment