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Can rational expectations sticky-price models explain inflation dynamics?

  • Jeremy B. Rudd
  • Karl Whelan

The canonical inflation specification in sticky-price rational expectations models (the new-Keynesian Phillips curve) is often criticized on the grounds that it fails to account for the dependence of inflation on its own lags. In response, many recent studies have employed a "hybrid" sticky-price specification in which inflation depends on a weighted average of lagged and expected future values of itself, in addition to a driving variable such as the output gap. In this paper, we consider some simple tests of the hybrid model that are derived from the model's closed-form solution. Our results suggest that the hybrid model provides a poor description of empirical inflation dynamics, and that there is little evidence of the type of rational forward-looking behavior implied by the model.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2003-46.

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Date of creation: 2003
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Handle: RePEc:fip:fedgfe:2003-46
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  1. Jeremy Rudd & Karl Whelan, 2005. "Does labor's share drive inflation?," Open Access publications 10197/243, School of Economics, University College Dublin.
  2. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," CEPR Discussion Papers 2139, C.E.P.R. Discussion Papers.
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  7. Rudd, Jeremy & Whelan, Karl, 2002. "Does the Labour Share of Income Drive Inflation?," Research Technical Papers 2/RT/02, Central Bank of Ireland.
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  16. Jeff Fuhrer & George Moore, 1995. "Inflation Persistence," The Quarterly Journal of Economics, Oxford University Press, vol. 110(1), pages 127-159.
  17. John B. Taylor, 1998. "Staggered Price and Wage Setting in Macroeconomics," NBER Working Papers 6754, National Bureau of Economic Research, Inc.
  18. Michael Ehrmann and Frank Smets, 2001. "Uncertain Potential Output: Implications for Monetary Policy," Computing in Economics and Finance 2001 8, Society for Computational Economics.
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  20. 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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