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P* revisited: money-based inflation forecasts with a changing equilibrium velocity

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  • Athanasios Orphanides
  • Richard D. Porter

Abstract

This paper implements recursive techniques to estimate the equilibrium level of M2 velocity and to forecast inflation using the P* model. The recursive estimates of equilibrium velocity are obtained by applying regression trees and least squares methods to a standard representation of M2 demand, namely a model in which the velocity of M2 depends on the opportunity cost of holding M2 instruments. Equilibrium velocity is defined as the level of velocity that would be expected to obtain if deposit rates were at their long-run average (equilibrium) value. We simulate the alternative models to obtain real-time forecasts of inflation and evaluate the performance of the forecasts obtained from the alternative models. We find that while a $P^*$ model assuming a constant equilibrium velocity does not provide accurate inflation forecasts in the 1990s, a model based on our time-varying equilibrium velocity estimates does quite well.

Suggested Citation

  • Athanasios Orphanides & Richard D. Porter, 1998. "P* revisited: money-based inflation forecasts with a changing equilibrium velocity," Finance and Economics Discussion Series 1998-26, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:1998-26
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    References listed on IDEAS

    as
    1. Joshua N. Feinman & Richard D. Porter, 1992. "The continuing weakness in the M2," Finance and Economics Discussion Series 209, Board of Governors of the Federal Reserve System (U.S.).
    2. Athanasios Orphanides & Brian Reid & David H. Small, 1994. "The empirical properties of a monetary aggregate that adds bond and stock funds to M2," Review, Federal Reserve Bank of St. Louis, issue Nov, pages 31-51.
    3. Sean Collins & William C. Whitesell, 1996. "A minor redefinition of M2," Finance and Economics Discussion Series 96-7, Board of Governors of the Federal Reserve System (U.S.).
    4. Evan F. Koenig, 1994. "The P* model of inflation revisited," Working Papers 9414, Federal Reserve Bank of Dallas.
    5. Hallman, Jeffrey J & Porter, Richard D & Small, David H, 1991. "Is the Price Level Tied to the M2 Monetary Aggregate in the Long Run?," American Economic Review, American Economic Association, vol. 81(4), pages 841-858, September.
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    Econometric models; Forecasting;

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