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Testing Price Equations

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  • Ray C. Fair

Abstract

How inflation and unemployment are related in both the short run and long run is perhaps the key question in macroeconomics. This paper tests various price equations using quarterly U.S. data from 1952 to the present. Issues treated are the following. 1) Estimating price and wage equations in which wages affect prices and vice versa versus estimating "reduced form" price equations with no wage explanatory variables. 2) Estimating price equations in (log) level terms, rst difference (i.e., inflation) terms, and second difference (i.e., change in inflation) terms. 3) The treatment of expectations. 4) The choice and functional form of the demand variable. 5) The choice of the cost-shock variable. The results reject the use of rational expectations and suggest that the best speci cation is a price equation in level terms imbedded in a price-wage model, where the wage equation is also in level terms. The best cost-shock variable is the import price deflator, and the best demand variable is the unemployment rate. There is some evidence of a nonlinear effect of the unemployment rate on the price level at low values of the unemployment rate. Many of the results in this paper are contrary to common views in the literature, but the empirical support for them is strong.

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Bibliographic Info

Paper provided by Kiel Institute for the World Economy in its series Kiel Working Papers with number 1342.

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Length: 29 pages
Date of creation: Jun 2007
Date of revision:
Handle: RePEc:kie:kieliw:1342

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  1. Jeremy Rudd & Karl Whelan, 2007. "Modeling Inflation Dynamics: A Critical Review of Recent Research," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(s1), pages 155-170, 02.
  2. Olivier Blanchard & Jordi Gali, 2005. "Real Wage Rigidities and the New Keynesian Model," NBER Working Papers 11806, National Bureau of Economic Research, Inc.
  3. Fuhrer, Jeffrey C, 1997. "The (Un)Importance of Forward-Looking Behavior in Price Specifications," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(3), pages 338-50, August.
  4. Lucas, Robert Jr, 1976. "Econometric policy evaluation: A critique," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 1(1), pages 19-46, January.
  5. Linde, Jesper, 2005. "Estimating New-Keynesian Phillips curves: A full information maximum likelihood approach," Journal of Monetary Economics, Elsevier, vol. 52(6), pages 1135-1149, September.
  6. George L. Perry, 1980. "Inflation in Theory and Practice," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 11(1, Tenth ), pages 207-260.
  7. Fair, Ray C., 2007. "Evaluating Inflation Targeting Using a Macroeconometric Model," Economics Discussion Papers 2007-14, Kiel Institute for the World Economy.
  8. Jeremy Rudd & Karl Whelan, 2006. "Can Rational Expectations Sticky-Price Models Explain Inflation Dynamics?," American Economic Review, American Economic Association, vol. 96(1), pages 303-320, March.
  9. Jordi Gali & Mark Gertler, 2000. "Inflation Dynamics: A Structural Econometric Analysis," NBER Working Papers 7551, National Bureau of Economic Research, Inc.
  10. Ray Fair, 2006. "Evaluating Inflation Targeting Using a Macroeconometric Model," Yale School of Management Working Papers amz2483, Yale School of Management, revised 01 Aug 2007.
  11. Robert E. Lucas, Jr. & N. Gregory Mankiw & Michael Woodford, 2005. "Panel discussion: understanding price determination: where are we now? where should we be going?," Proceedings, Board of Governors of the Federal Reserve System (U.S.).
  12. Ray C. Fair & John B. Taylor, 1991. "Full Information Estimation and Stochastic Simulation of Models with Rational Expectations," NBER Technical Working Papers 0078, National Bureau of Economic Research, Inc.
  13. Jeremy Rudd & Karl Whelan, 2001. "New tests of the New-Keynesian Phillips curve," Finance and Economics Discussion Series 2001-30, Board of Governors of the Federal Reserve System (U.S.).
  14. Kurmann, Andre, 2007. "VAR-based estimation of Euler equations with an application to New Keynesian pricing," Journal of Economic Dynamics and Control, Elsevier, vol. 31(3), pages 767-796, March.
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Cited by:
  1. Malikane, Christopher, 2013. "A New Keynesian Triangle Phillips Curve," MPRA Paper 43548, University Library of Munich, Germany.
  2. Ray C. Fair, 2009. "Possible Macroeconomic Consequences of Large Future Federal Government Deficits," Cowles Foundation Discussion Papers 1727, Cowles Foundation for Research in Economics, Yale University, revised Feb 2010.
  3. Malikane, Christopher, 2012. "The Microfoundations of the Keynesian Wage-Price Spiral," MPRA Paper 42923, University Library of Munich, Germany, revised 2012.
  4. Fair, Ray C., 2012. "Has macro progressed?," Journal of Macroeconomics, Elsevier, vol. 34(1), pages 2-10.
  5. Malikane, Christopher & Mokoka, Tshepo, 2012. "Monetary policy credibility: A Phillips curve view," The Quarterly Review of Economics and Finance, Elsevier, vol. 52(3), pages 266-271.
  6. Dufour, Jean-Marie & Khalaf, Lynda & Kichian, Maral, 2013. "Identification-robust analysis of DSGE and structural macroeconomic models," Journal of Monetary Economics, Elsevier, vol. 60(3), pages 340-350.

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