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Cointegration-based tests of the New Keynesian Model of inflation

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  • David Demery
  • Nigel Duck

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    Abstract

    We show that the New-Keynesian (NK) model of inflation can be interpreted as a forward-looking cointegrated model. This allows us to model firms' expectations about marginal costs in a simple VAR framework and develop relatively simple formal tests of the model which bypass the econometric problems faced by other approaches. We show that a series of Granger-causality tests can indicate whether there is some forward-looking component to price setting. We implement these tests using quarterly data for the UK and the US. We find that the NK model is formally rejected but that there is strong evidence of a forward looking component to price setting.

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    File URL: http://www.efm.bris.ac.uk/economics/working_papers/pdffiles/dp02541.pdf
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    Bibliographic Info

    Paper provided by Department of Economics, University of Bristol, UK in its series Bristol Economics Discussion Papers with number 02/541.

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    Length: 23 pages
    Date of creation: Aug 2002
    Date of revision:
    Handle: RePEc:bri:uobdis:02/541

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    Keywords: new-Keynesian; inflation; coeintegration;

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    1. Sbordone, Argia, 1998. "Prices and Unit Labor Costs: A New Test of Price Stickiness," Seminar Papers 653, Stockholm University, Institute for International Economic Studies.
    2. Simon Hall & Mark Walsh & Anthony Yates, 1997. "How do UK companies set prices?," Bank of England working papers 67, Bank of England.
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    4. Hall, Robert E, 1978. "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 971-87, December.
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    8. Michael Woodford, 1996. "Control of the Public Debt: A Requirement for Price Stability?," NBER Working Papers 5684, National Bureau of Economic Research, Inc.
    9. John B. Taylor, 1998. "Staggered Price and Wage Setting in Macroeconomics," NBER Working Papers 6754, National Bureau of Economic Research, Inc.
    10. N. Gregory Mankiw, 2000. "The Inexorable and Mysterious Tradeoff Between Inflation and Unemployment," NBER Working Papers 7884, National Bureau of Economic Research, Inc.
    11. Kwiatkowski, D. & Phillips, P.C.B. & Schmidt, P., 1990. "Testing the Null Hypothesis of Stationarity Against the Alternative of Unit Root : How Sure are we that Economic Time Series have a Unit Root?," Papers 8905, Michigan State - Econometrics and Economic Theory.
    12. Basma Bekdache & Christopher F. Baum, 1999. "A re-evaluation of empirical tests of the Fisher hypothesis," Computing in Economics and Finance 1999 944, Society for Computational Economics, revised 18 Sep 2000.
    13. Alan S. Blinder & Angus Deaton, 1985. "The Time Series Consumption Function Revisited," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 16(2), pages 465-521.
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