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Time-Varying U.S. Inflation Dynamics and the New Keynesian Phillips Curve

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  • Kevin J. Lansing

Abstract

This paper introduces a form of boundedly-rational expectations into an otherwise standard New-Keynesian Phillips curve. The representative agent's forecast rule is optimal (in the sense of minimizing mean squared forecast errors), conditional on a perceived law of motion for inflation and observed moments of the inflation time series. The perceived law of motion allows for both temporary and permanent shocks to inflation, the latter intended to capture the possibility of evolving shifts in the central bank's inflation target. In this case, the agent's optimal forecast rule defined by the Kalman filter coincides with adaptive expectations, as shown originally by Muth (1960). I show that the perceived optimal value of the gain parameter assigned to the last observed inflation rate is given by the fixed point of a nonlinear map that relates the gain parameter to the autocorrelation of inflation changes. The model allows for either a constant gain or variable gain, depending on the length of the sample period used by the agent to compute the autocorrelation of inflation changes. In the variable-gain setup, the equilibrium law of motion for inflation is nonlinear and can generate time-varying inflation dynamics similar to those observed in long-run U.S. data. The model's inflation dynamics are driven solely by white-noise fundamental shocks propagated via the expectations feedback mechanism; all monetary policy-dependent parameters are held constant

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Paper provided by Society for Economic Dynamics in its series 2006 Meeting Papers with number 758.

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Date of creation: 03 Dec 2006
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Handle: RePEc:red:sed006:758

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Keywords: Inflation Expectations; Phillips Curve; Time-Varying Persistence & Volatility;

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Cited by:
  1. J. Scott Davis, 2012. "The effect of commodity price shocks on underlying inflation: the role of central bank credibility," Globalization and Monetary Policy Institute Working Paper 134, Federal Reserve Bank of Dallas.
  2. Lansing, Kevin J., 2012. "Speculative growth, overreaction, and the welfare cost of technology-driven bubbles," Journal of Economic Behavior & Organization, Elsevier, vol. 83(3), pages 461-483.
  3. Branch, William A. & McGough, Bruce, 2009. "A New Keynesian model with heterogeneous expectations," Journal of Economic Dynamics and Control, Elsevier, vol. 33(5), pages 1036-1051, May.
  4. Hommes, Cars & Zhu, Mei, 2014. "Behavioral learning equilibria," Journal of Economic Theory, Elsevier, vol. 150(C), pages 778-814.
  5. Davis, Scott & Mack, Adrienne, 2013. "Cross-country variation in the anchoring of inflation expectations," Staff Papers, Federal Reserve Bank of Dallas, issue Oct.
  6. Hommes, C.H., 2013. "Behaviorally Rational Expectations and Almost Self-Fulfilling Equilibria," CeNDEF Working Papers 13-17, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
  7. Paul Castillo & Alberto Humala & Vicente Tuesta, 2007. "Monetary Policy, Regime Shifts, and Inflation Uncertainty in Peru (1949-2006)," Working Papers 2007-005, Banco Central de Reserva del Perú.
  8. Lena Dräger, 2011. "Endogenous Persistence with Recursive Inattentiveness," KOF Working papers 11-285, KOF Swiss Economic Institute, ETH Zurich.
  9. Cars Hommes, 2013. "Behaviorally Rational Expectations and Almost Self-Fulfilling Equilibria," Tinbergen Institute Discussion Papers 13-204/II, Tinbergen Institute.

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