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Rational Bias in Inflation Expectations

Author

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  • Robert G. Murphy

    () (Boston College)

  • Adam Rohde

    (Charles River Associates)

Abstract

This paper argues that individuals may rationally weight price increases for food and energy products differently from their expenditure shares when forming expectations about price inflation. We develop a simple dynamic model of the economy with gradual price adjustment in the core sector and flexible prices in the food and energy sectors. Serial correlation of supply shocks to food and energy allows individuals to gain an understanding about future shocks, possibly making it optimal for individuals to place more weight on the movement of prices in these sectors. We use survey data on expected inflation to show that the weights implied by the model differ from the expenditure shares of food and energy prices in the CPI for the United States. We find food price inflation is weighted more heavily and energy price inflation is weighted less heavily. But importantly, we cannot reject the hypothesis that these weights reflect rational behavior in forming expectations about inflation.

Suggested Citation

  • Robert G. Murphy & Adam Rohde, 2014. "Rational Bias in Inflation Expectations," Boston College Working Papers in Economics 857, Boston College Department of Economics, revised 25 Oct 2015.
  • Handle: RePEc:boc:bocoec:857
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    References listed on IDEAS

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    1. Arora, Vipin & Gomis-Porqueras, Pedro & Shi, Shuping, 2013. "The divergence between core and headline inflation: Implications for consumers’ inflation expectations," Journal of Macroeconomics, Elsevier, pages 497-504.
    2. N. Gregory Mankiw & Ricardo Reis, 2002. "Sticky Information versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve," The Quarterly Journal of Economics, Oxford University Press, vol. 117(4), pages 1295-1328.
    3. Jeffrey C. Fuhrer, 1995. "The Phillips curve is alive and well," New England Economic Review, Federal Reserve Bank of Boston, issue Mar, pages 41-56.
    4. Murphy, Robert G., 2014. "Explaining inflation in the aftermath of the Great Recession," Journal of Macroeconomics, Elsevier, pages 228-244.
    5. Jordi Galí, 2011. "The Return Of The Wage Phillips Curve," Journal of the European Economic Association, European Economic Association, vol. 9(3), pages 436-461, June.
    6. Michael Pedersen, 2011. "Propagation of Shocks to Food and Energy Prices: an International Comparison," Working Papers Central Bank of Chile 648, Central Bank of Chile.
    7. Benjamin Wong, 2015. "Do Inflation Expectations Propagate the Inflationary Impact of Real Oil Price Shocks?: Evidence from the Michigan Survey," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 47(8), pages 1673-1689, December.
    8. Mullineaux, Donald J, 1978. "On Testing for Rationality: Another Look at the Livingston Price Expectations Data," Journal of Political Economy, University of Chicago Press, vol. 86(2), pages 329-336, April.
    9. Georganas, Sotiris & Healy, Paul J. & Li, Nan, 2014. "Frequency bias in consumers׳ perceptions of inflation: An experimental study," European Economic Review, Elsevier, vol. 67(C), pages 144-158.
    10. Murphy, Robert G., 1986. "The expectations theory of the term structure: Evidence from inflation forecasts," Journal of Macroeconomics, Elsevier, pages 423-434.
    11. Oya Celasun & Lev Ratnovski & Roxana Mihet, 2012. "Commodity Prices and Inflation Expectations in the United States," IMF Working Papers 12/89, International Monetary Fund.
    12. Frederic S. Mishkin, 2007. "Inflation Dynamics," International Finance, Wiley Blackwell, vol. 10(3), pages 317-334, December.
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    Cited by:

    1. Jasmien De Winne & Gert Peersman, 2016. "Macroeconomic Effects of Disruptions in Global Food Commodity Markets: Evidence for the United States," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 47(2 (Fall)), pages 183-286.

    More about this item

    Keywords

    Inflation Expectations; Core Inflation; Food and Energy Prices; Anchored Expectations;

    JEL classification:

    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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