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Inflation dynamics in the euro area and the role of expectations: further results

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  • Paloviita , Maritta

    ()
    (Bank of Finland Research)

Abstract

This paper examines the empirical performance of the New Keynesian Phillips curve and its hybrid specification in the euro area. Instead of imposing rational expectations, direct measures, ie OECD forecasts, are used as empirical proxies for economic agents´ inflation expectations. Real marginal costs are proxied by three different measures. The results suggest that OECD inflation forecasts perform relatively well as a proxy for inflation expectations in the euro area, since under this approach the European inflation process can be modeled using the forward-looking New Keynesian Phillips curve. However, inflation can be modeled even more accurately by the hybrid Phillips curve. Thus, even allowing for possible non-rationality in expectations, the additional lagged inflation term is needed in the New Keynesian Phillips relation. In this approach, the output gap turns out to be at least as good a proxy for real marginal costs as the labor income share. Moreover, the inflation process seems to have become more forward-looking in the recent years of low and stable inflation.

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File URL: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Documents/0421.pdf
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Bibliographic Info

Paper provided by Bank of Finland in its series Research Discussion Papers with number 21/2004.

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Length: 28 pages
Date of creation: 13 Oct 2004
Date of revision:
Publication status: Published in Empirical Economics, 2006, pages 847-860.
Handle: RePEc:hhs:bofrdp:2004_021

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Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
Web page: http://www.suomenpankki.fi/en/
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Related research

Keywords: Phillips curve; expectations; euro area;

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References

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  1. Gali, Jordi & Gertler, Mark & Lopez-Salido, J. David, 2001. "European inflation dynamics," European Economic Review, Elsevier, vol. 45(7), pages 1237-1270.
  2. Rotemberg, Julio J, 1982. "Monopolistic Price Adjustment and Aggregate Output," Review of Economic Studies, Wiley Blackwell, vol. 49(4), pages 517-31, October.
  3. Robert G. King, 2000. "The new IS-LM model : language, logic, and limits," Economic Quarterly, Federal Reserve Bank of Richmond, issue Sum, pages 45-103.
  4. Klaus Adam & Mario Padula, 2002. "Inflation Dynamics and Subjective Expectations in the United States," CSEF Working Papers 78, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy, revised 02 Jun 2009.
  5. Sbordone, Argia M., 2002. "Prices and unit labor costs: a new test of price stickiness," Journal of Monetary Economics, Elsevier, vol. 49(2), pages 265-292, March.
  6. Michael J. Artis, 1996. "How Accurate Are the Imf's Short-Term Forecasts? Another Examination of the World Economic Outlook," IMF Working Papers 96/89, International Monetary Fund.
  7. Forsells, Magnus & Kenny, Geoff, 2002. "The rationality of consumers' inflation expectations: survey-based evidence for the euro area," Working Paper Series 0163, European Central Bank.
  8. John M. Roberts, 2001. "How well does the New Keynesian sticky-price model fit the data?," Finance and Economics Discussion Series 2001-13, Board of Governors of the Federal Reserve System (U.S.).
  9. Taylor, John B, 1980. "Aggregate Dynamics and Staggered Contracts," Journal of Political Economy, University of Chicago Press, vol. 88(1), pages 1-23, February.
  10. Maritta Paloviita, 2006. "Inflation Dynamics in the Euro Area and the Role of Expectations," Empirical Economics, Springer, vol. 31(4), pages 847-860, November.
  11. Laurence Ball, 2000. "Near-Rationality and Inflation in Two Monetary Regimes," Economics Working Paper Archive 435, The Johns Hopkins University,Department of Economics.
  12. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  13. Roberts, John M., 1997. "Is inflation sticky?," Journal of Monetary Economics, Elsevier, vol. 39(2), pages 173-196, July.
  14. Katharine Neiss & Edward Nelson, 2002. "Inflation dynamics, marginal cost, and the output gap: evidence from three countries," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  15. Ash, J. C. K. & Smyth, D. J. & Heravi, S. M., 1998. "Are OECD forecasts rational and useful?: a directional analysis," International Journal of Forecasting, Elsevier, vol. 14(3), pages 381-391, September.
  16. John M. Roberts, 1998. "Inflation expectations and the transmission of monetary policy," Finance and Economics Discussion Series 1998-43, Board of Governors of the Federal Reserve System (U.S.).
  17. Jeremy Rudd & Karl Whelan, 2002. "Should monetary policy target labor's share of income?," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
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Citations

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Cited by:
  1. Kevin D. Sheedy, 2007. "Intrinsic Inflation Persistence," CEP Discussion Papers dp0837, Centre for Economic Performance, LSE.
  2. Michel Juillard & Ondrej Kamenik & Michael Kumhof & Douglas Laxton, 2006. "Measures of Potential Output from an Estimated DSGE Model of the United States," Working Papers 2006/11, Czech National Bank, Research Department.
  3. Männistö , Hanna-Leena, 2005. "Forecasting with a forward-looking DGE model: combining long-run views of financial markets with macro forecasting," Research Discussion Papers 21/2005, Bank of Finland.
  4. Juan José Echavarría S. & Enrique López E. & Martha Misas A., 2010. "La persistencia estadística de la inflación en Colombia," BORRADORES DE ECONOMIA 007573, BANCO DE LA REPÚBLICA.
  5. Ignazio Angeloni & Luc Aucremanne & Michael Ehrmann & Jordi Galí & Andrew Levin & Frank Smets, 2006. "New Evidence on Inflation Persistence and Price Stickiness in the Euro Area: Implications for Macro Modeling," Journal of the European Economic Association, MIT Press, vol. 4(2-3), pages 562-574, 04-05.
  6. Ivo J.M. Arnold & Jan J.G. Lemmen, 2008. "Inflation Expectations and Inflation Uncertainty in the Eurozone: Evidence from Survey Data," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 144(2), pages 325-346, July.
  7. Steffen Henzel & Timo Wollmershäuser, 2006. "The New Keynesian Phillips Curve and the Role of Expectations: Evidence from the Ifo World Economic Survey," CESifo Working Paper Series 1694, CESifo Group Munich.
  8. Juillard, Michael & Kamenik, Ondra & Kumhof, Michael & Laxton, Douglas, 2008. "Optimal price setting and inflation inertia in a rational expectations model," Journal of Economic Dynamics and Control, Elsevier, vol. 32(8), pages 2584-2621, August.

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