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Inflation Dynamics and Inflation Regimes

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  • David Demery
  • Nigel Duck

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    Abstract

    In this paper we develop and estimate a new-Keynesian model of inflation and use it to investigate the hypothesis that prices in the UK are re-set more frequently during periods of high inflation. In the model, firms are assumed to condition their expectations on an optimally-selected but incomplete information set and we further assume that the probability that they will reset their price in any quarter depends upon the prevailing inflationary regime. The model implies more complex inflation dynamics than conventional new-Keynesian models predict. We find that we cannot reject the formal restrictions implied by the model (using UK quarterly data) and we estimate that the mean time before prices were reset was around eight months during the 'high' inflationary regime and approximately two years when mean inflation was 'low'.

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    File URL: http://www.efm.bris.ac.uk/economics/working_papers/pdffiles/dp03549.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 03/549.

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    Length: 25 pages
    Date of creation: Feb 2003
    Date of revision:
    Handle: RePEc:bri:uobdis:03/549

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    Related research

    Keywords: Rational expectations; incomplete information; macroeconomic dynamics; regime switching;

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    References

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    1. N. Gregory Mankiw & Ricardo Reis, 2001. "Sticky information versus sticky prices: a proposal to replace the New-Keynesian Phillips curve," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
    2. Jeff Fuhrer & George Moore, 1993. "Inflation persistence," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
    3. David Demery & Nigel Duck, 2002. "Optimally Rational Expectations and Macroeconomics," Bristol Economics Discussion Papers 02/533, Department of Economics, University of Bristol, UK.
    4. Michael Woodford, 2001. "Imperfect Common Knowledge and the Effects of Monetary Policy," NBER Working Papers 8673, National Bureau of Economic Research, Inc.
    5. Newey, Whitney K & West, Kenneth D, 1987. "Hypothesis Testing with Efficient Method of Moments Estimation," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 28(3), pages 777-87, October.
    6. Laurence Ball & N. Gregory Mankiw & David Romer, 1988. "The New Keynsesian Economics and the Output-Inflation Trade-off," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 19(1), pages 1-82.
    7. Crettez, Bertrand & Michel, Philippe, 1992. "Economically rational expectations equilibrium," Economics Letters, Elsevier, vol. 40(2), pages 203-206, October.
    8. Hamilton, James D., 1990. "Analysis of time series subject to changes in regime," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 39-70.
    9. Laurence Ball, 2000. "Near-Rationality and Inflation in Two Monetary Regimes," NBER Working Papers 7988, National Bureau of Economic Research, Inc.
    10. John Conlisk, 1996. "Why Bounded Rationality?," Journal of Economic Literature, American Economic Association, vol. 34(2), pages 669-700, June.
    11. Mankiw, N Gregory, 2001. "The Inexorable and Mysterious Tradeoff between Inflation and Unemployment," Economic Journal, Royal Economic Society, vol. 111(471), pages C45-61, May.
    12. John M. Roberts, 1994. "Is inflation sticky?," Working Paper Series / Economic Activity Section 152, Board of Governors of the Federal Reserve System (U.S.).
    13. Galbraith, John W, 1988. "Modelling Expectations Formation with Measurement Errors," Economic Journal, Royal Economic Society, vol. 98(391), pages 412-28, June.
    14. 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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