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Can Rational Expectations Sticky-Price Models Explain Inflation Dynamics

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  • Rudd, Jeremy

    (Federal Reserve Board)

  • Whelan, Karl

    (Central Bank and Financial Services Authority of Ireland)

Abstract

Recent years have seen an important trend in macroeconomic research towards analysing business cycles and stabilization policy in the context of models that incorporate both nominal rigidities and optimising agents with rational expectations. The canonical specification for the behaviour of inflation in these sticky-price rational expectations models (which is known as the new-Keynesian Phillips curve) is often criticized on the grounds that it fails to account for the dependence of inflation on its own lags. In response, many recent studies have employed a “hybrid” sticky-price specification in which inflation depends on a weighted average of lagged and expected future values of itself, in addition to a driving variable such as the output gap. In this paper, we consider some simple tests of the hybrid model that are derived from the model's closed-form solution. Our results suggest that the hybrid model provides a poor description of empirical inflation dynamics, and that there is little evidence of the type of rational forward-looking behavior implied by the model.

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Bibliographic Info

Paper provided by Central Bank of Ireland in its series Research Technical Papers with number 5/RT/03.

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Length: 32 pages
Date of creation: Aug 2003
Date of revision:
Handle: RePEc:cbi:wpaper:5/rt/03

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