Estimates of the Phillips curve suggest that the low level of unemployment over the last few years should have produced a fairly significant increase in the rate of inflation, yet inflation has continued to fall. Some take this occurrence as evidence that the NAIRU has declined. Others argue that special factors, such as recent movements of employee health coverage to health maintenance organizations, have temporarily masked the increase in inflation. Perhaps the most widely cited explanation for the surprisingly good inflation performance of late concerns the increasing sensitivity of the U.S. economy to foreign economic conditions; specifically, many have argued that since capacity utilization abroad has been slack in recent years, U.S. inflation has remained mild.
This study uses a variety of approaches to examine whether U.S. inflation depends on foreign, rather than domestic, capacity constraints. The author shows that foreign capacity plays little, if any, role in the determination of U.S. inflation independent of any role it might play in the determination of U.S. capacity utilization. He cautions that anyone who believes in a world where we no longer need worry about domestic capapcity constraints will eventually be rudely awakened by data that suggest otherwise. His results indicate that the Phillips curve, relating some measure of U.S. capacity utilization to U.S. inflation, is alive, if ailing a bit, even as the world gets more integrated.