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The output gap, expected future inflation and inflation dynamics: another look

  • Yash P. Mehra
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    The empirical test of the output gap-based New Keynesian Phillips curve often has been implemented by estimating a hybrid specification that includes both lagged and future inflation and then by examining whether the estimated coefficient on future inflation is significantly larger than the one on lagged inflation. This article presents the evidence that indicates supply shocks significantly enter the hybrid specification. The results reported in previous research — the output gap is irrelevant and expected future inflation is the major determinant of inflation — arise if the hybrid specification is estimated omitting supply shocks and/or lagged inflation. In the hybrid specification estimated with supply shocks, the output gap is significant. The estimated coefficient on future inflation is quantitatively small, but the estimated coefficient on lagged inflation is significantly larger than the one on future inflation. The null hypothesis that the estimated coefficient on lagged inflation is unity is not rejected if the hybrid specification nests an alternative version of the traditional Phillips curve in which inflation responds also to a change in the output gap. Together these results suggest that expected future inflation is not the major determinant of current inflation.

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    Paper provided by Federal Reserve Bank of Richmond in its series Working Paper with number 04-06.

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    Date of creation: 2004
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    Handle: RePEc:fip:fedrwp:04-06
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    1. Fuhrer, Jeffrey C, 1997. "The (Un)Importance of Forward-Looking Behavior in Price Specifications," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(3), pages 338-50, August.
    2. Fuhrer, Jeff & Moore, George, 1995. "Inflation Persistence," The Quarterly Journal of Economics, MIT Press, vol. 110(1), pages 127-59, February.
    3. N. Gregory Mankiw & Ricardo Reis, 2001. "Sticky Information Versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve," Harvard Institute of Economic Research Working Papers 1922, Harvard - Institute of Economic Research.
    4. Jordi Galí & Mark Gertler, 1998. "Inflation dynamics: A structural econometric analysis," Economics Working Papers 341, Department of Economics and Business, Universitat Pompeu Fabra.
    5. Michael Dotsey, 2002. "Pitfalls in interpreting tests of backward-looking pricing in New Keynesian models," Economic Quarterly, Federal Reserve Bank of Richmond, issue Win, pages 37-50.
    6. Rudd, Jeremy & Whelan, Karl, 2005. "New tests of the new-Keynesian Phillips curve," Journal of Monetary Economics, Elsevier, vol. 52(6), pages 1167-1181, September.
    7. Hodrick, Robert J & Prescott, Edward C, 1997. "Postwar U.S. Business Cycles: An Empirical Investigation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(1), pages 1-16, February.
    8. Mark Bils & Yongsung Chang, 1999. "Understanding How Price Responds to Costs and Production," NBER Working Papers 7311, National Bureau of Economic Research, Inc.
    9. Roberts, John M, 1995. "New Keynesian Economics and the Phillips Curve," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(4), pages 975-84, November.
    10. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
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