ASYMMETRIC OUTPUT-GAP EFFECTS IN PHILLIPS CURVE AND MARK-UP PRICING MODELS: EVIDENCE FOR THE US AND THE UK Michael P. Clements n and Marianne Sensier nn Abstract A number of studies have found an asymmetric response of consumer price index inflation to the output gap in the US in simple Phillips curve models. We consider whether there are similar asymmetries in mark-up pricing models, that is, whether the mark-up over producers’ costs also depends upon the sign of the (adjusted) output gap. The robustness of our findings to the price series is assessed, and also whether price-output responses in the UK are asymmetric. I Introduction A number of recent papers have argued that the relationship between inflation and excess demand, as measured by the ‘output gap’, is non-linear or asymmetric – a given amount of unemployment below the non-accelerating inflation rate of unemployment (NAIRU) is more inflationary than an equivalent excess of unemployment is deflationary. 1 In a linear world, the natural rate hypothesis suggests that demand management policies are unable to raise the average level of output without simultaneously increasing inflation. This stark implication results from re-arranging the stylized Phillips curve, p t 5 p t  1 1bD t , where p t is inflation and D t is the deviation in output (or employment) from the natural rate, to give P T t¼1 D t ¼ b 1 ðp T  p 0 Þ. Hence for the same rate of inflation at the beginning and end of a given time period, p T 5 p 0 , any ‘filling in of troughs’ is at the cost of ‘shaved-off peaks’, since P T t¼1 D t ¼ 0 (see, e.g., De Long and Summers, 1988). The asymmetry hypothesis emphasises shaving off peaks to avoid the disproportionately greater recessionary costs to reigning in inflation at a later date. Thus demand management policies that are effective in preventing booms can result in a higher average level of output. n University of Warwick nn University of Manchester 1 See, e.g., Chadha, Masson and Meredith (1992), Laxton, Meredtch and Rose (1995), Turner (1995), Clark, Laxton and Rose (1996), Clark and Laxton (1997) and Laxton, Rose and Tambakis (1999). Scottish Journal of Political Economy, Vol. 50, No. 4, September 2003 r Scottish Economic Society 2003, Published by Blackwell Publishing, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA 359