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Dynamics of inflation expectations in the euro area

The present study examines empirically the inflation dynamics of the euro area. The focus of the analysis is on the role of expectations in the inflation process. In six articles we relax rationality assumption and proxy expectations directly using OECD forecasts or Consensus Economics survey data. In the first four articles we estimate alternative Phillips curve specifications and find evidence that inflation cannot instantaneously adjust to changes in expectations. A possible departure of expectations from rationality seems not to be powerful enough to totally explain the persistence of euro area inflation in the New Keynesian framework. When expectations are measured directly, the purely forward-looking New Keynesian Phillips curve is outperformed by the hybrid Phillips curve with an additional lagged inflation term and the New Classical Phillips curve with a lagged expectations term. The results suggest that the euro area inflation process has become more forward-looking in the recent years of low and stable inflation. Moreover, in low inflation countries, the inflation dynamics have been more forward-looking already since the late 1970s. We find evidence of substantial heterogeneity of inflation dynamics across the euro area countries. Real time data analysis suggests that in the euro area real time information matters most in the expectations term in the Phillips curve and that the balance of expectations formation is more forward- than backward-looking. Vector autoregressive (VAR) models of actual inflation, inflation expectations and the output gap are estimated in the last two articles. The VAR analysis indicates that inflation expectations, which are relatively persistent, have a significant effect on output. However, expectations seem to react to changes in both output and actual inflation, especially in the medium term. Overall, this study suggests that expectations play a central role in inflation dynamics, which should be taken into account in conducting monetary policy.

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File URL: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/erillisjulkaisut/Documents/E40.pdf
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Paper provided by Bank of Finland in its series Scientific Monographs with number E:40/2009.

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Length: 61 pages
Date of creation: 15 Jan 2009
Date of revision:
Handle: RePEc:hhs:bofism:2009_040
Contact details of provider: Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
Web page: http://www.suomenpankki.fi/en/

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