Estimating NAIRU for the Turkish Economy Using Extended Kalman Filter Approach

Estimating NAIRU for the Turkish Economy Using Extended Kalman Filter Approach

Title:

Estimating NAIRU for the Turkish Economy Using Extended Kalman Filter Approach

Number:

14/06

Author(s):

Vuslat Us

Language:

English

Date:

March 2014

Abstract:

This paper estimates NAIRU (Non-Accelerating Inflation Rate of Unemployment) for the Turkish economy as an unobserved stochastic variable. In doing so, the study adopts an empirical framework that is based on a systems approach. More specifically, the framework combines an Okun-type relationship between output gap and unemployment gap with a Phillips curve equation, and also imposes stochastic laws of motion for NAIRU and potential output, while assuming the parameters to be time-varying. However, the requirement to simultaneously estimate parameters and to solve the state-space problem introduces nonlinearity, which can be handled by employing Extended Kalman Filter (EKF), i.e. the use of standard Kalman filter equations to the first-order Taylor approximation of the nonlinear model about the last estimate. Estimation results suggest that NAIRU moves in tandem with the actual unemployment, but it follows a more volatile path than the latter. Accordingly, the estimated NAIRU series reacts more sharply to the crises than the actual unemployment. This observation is in line with the prior studies reporting the relatively persistent nature of actual unemployment compared to the non-accelerating inflation rate of unemployment. All of the derived series are plausible and capture the significant turning points of the economy. As for coefficients, the time-varying parameters indicate a stable, yet quite a weak link between unemployment and inflation. Meanwhile, the coefficient of exchange rate in the Phillips curve equation suggests a weakening, but significant pass-through to inflation. Moreover, estimation results also point to the presence of considerable inertia in inflation. To sum up, findings of this study provide guidance for future research on NAIRU, which is an important tool for monetary policy. The findings also lay the basis for further work that may adopt EKF. But most importantly, this study emphasizes the need for a more flexible and comprehensive framework for the conduct of monetary policy.

Keywords:

NAIRU, Systems approach, Phillips curve, Okun law, Time-varying parameter, Extended Kalman Filter, Inertia, Monetary policy

JEL Codes:

C32; C63; E24; E31

Estimating NAIRU for the Turkish Economy Using Extended Kalman Filter Approach
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