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Can Rational Expectations Sticky-Price Models Explain Inflation Dynamics?

  • Jeremy Rudd
  • Karl Whelan

The canonical inflation specification in sticky-price rational expectations models (the new-Keynesian Phillips curve) is often criticized for failing to account for the dependence of inflation on its own lags. In response, many studies employ a "hybrid" specification in which inflation depends on its lagged and expected future values, together with a driving variable such as the output gap. We consider some simple tests of the hybrid model that are derived from its closed form. We find that the hybrid model describes inflation dynamics poorly, and find little empirical evidence for the type of rational, forward-looking behavior that the model implies.

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Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 96 (2006)
Issue (Month): 1 (March)
Pages: 303-320

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Handle: RePEc:aea:aecrev:v:96:y:2006:i:1:p:303-320
Note: DOI: 10.1257/000282806776157560
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  1. Ehrmann, Michael & Smets, Frank, 2003. "Uncertain potential output: implications for monetary policy," Journal of Economic Dynamics and Control, Elsevier, vol. 27(9), pages 1611-1638, July.
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  8. Douglas O. Staiger & James H. Stock & Mark W. Watson, 1997. "How Precise Are Estimates of the Natural Rate of Unemployment?," NBER Chapters, in: Reducing Inflation: Motivation and Strategy, pages 195-246 National Bureau of Economic Research, Inc.
  9. Jeff Fuhrer & George Moore, 1995. "Inflation Persistence," The Quarterly Journal of Economics, Oxford University Press, vol. 110(1), pages 127-159.
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  11. Karl Whelan & Jeremy Rudd, 2002. "Does the labour share of income drive inflation?," Open Access publications 10197/233, School of Economics, University College Dublin.
  12. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
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  15. Guerrieri, Luca, 2006. "The Inflation Persistence of Staggered Contracts," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(2), pages 483-494, March.
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  18. Robert J. Gordon, 1998. "Foundations of the Goldilocks Economy: Supply Shocks and the Time-Varying NAIRU," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(2), pages 297-346.
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  23. Casares, Miguel & McCallum, Bennett T., 2006. "An optimizing IS-LM framework with endogenous investment," Journal of Macroeconomics, Elsevier, vol. 28(4), pages 621-644, December.
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