This paper investigates the indicator properties of the price gap concept, recently advocated by economists of the Federal Reserve and applied by the Deutsche Bundesbank for German data. In the theoretical analysis it is argued that the price gap hypothesis is consistent with conventional macroeconomic models only under a number of very restrictive assumptions. In a Phillips curve type interpretation the output gap measures demand pressure in the goods market while the velocity gap is a proxy for inflation expectations. In order to capture expectations, nominal interest rates may be less inflicted with specification and measurement error under standard macroeconomic assumptions, than the velocity gap variable proposed by the P-star hypothesis. This conjecture is confirmed by our regression results. We believe that the results reported here are sufficient to raise severe doubts on the usefullness of the P-star concept for Germany.
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Article provided by Department of Economics, Economics I, Bayreuth University in its journal Macroeconomics.