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Implications of the permanent-transitory confusion for New-Keynesian modeling, inflation forecasts and the post-crisis era

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  • Cukierman, Alex

Abstract

Decisions about consumption, work, leisure, pricing, investment and other private and public policy decisions rely on forecasts of the future. The permanent-transitory confusion (PTC) refers to the fact that even when they know all past and current information individuals are uncertain about the persistence of the current state. This all pervasive informational limitation makes it optimal, in general, to use all past information when forecasting the future even under rational expectations. The objective of this paper is to remind the profession of this basic fact and point out some of its implications by showing at both the theoretical and the empirical levels that forecasts of the future are generally adaptive in the sense that they depend on available past information even when information is utilized efficiently. This is done along the following dimensions. First by briefly surveying the literature on rational-adaptive expectations from Muth (1960) to Coibion-Gorodnichenko (2015). Second, by showing that the PTC injects the past even into purely forward looking New-Keynesian such as that of Clarida, Gali & Gertler (1999). Third, by showing empirically that inflationary expectations in the US Survey of Professional Forecasters rely on past inflation. The paper concludes with reflections on the persistence of economic and policy changes induced by the global financial crisis.

Suggested Citation

  • Cukierman, Alex, 2019. "Implications of the permanent-transitory confusion for New-Keynesian modeling, inflation forecasts and the post-crisis era," CEPR Discussion Papers 13727, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:13727
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    References listed on IDEAS

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    1. Andrade, Philippe & Le Bihan, Hervé, 2013. "Inattentive professional forecasters," Journal of Monetary Economics, Elsevier, vol. 60(8), pages 967-982.
    2. Orphanides, Athanasios & Williams, John C., 2005. "The decline of activist stabilization policy: Natural rate misperceptions, learning, and expectations," Journal of Economic Dynamics and Control, Elsevier, vol. 29(11), pages 1927-1950, November.
    3. 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.
    4. Milton Friedman, 1957. "Introduction to "A Theory of the Consumption Function"," NBER Chapters,in: A Theory of the Consumption Function, pages 1-6 National Bureau of Economic Research, Inc.
    5. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
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    7. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, vol. 50(6), pages 1345-1370, November.
    8. Olivier Coibion & Yuriy Gorodnichenko, 2015. "Information Rigidity and the Expectations Formation Process: A Simple Framework and New Facts," American Economic Review, American Economic Association, vol. 105(8), pages 2644-2678, August.
    9. Steinsson, Jon, 2003. "Optimal monetary policy in an economy with inflation persistence," Journal of Monetary Economics, Elsevier, vol. 50(7), pages 1425-1456, October.
    10. Milton Friedman, 1957. "A Theory of the Consumption Function," NBER Books, National Bureau of Economic Research, Inc, number frie57-1, September.
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    More about this item

    Keywords

    inflationary expectations; Permanent-transitory confusion; rationally adaptive expectations - implications for New-Keynesian framework;

    JEL classification:

    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation

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