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Irrational Bias in Inflation Forecasts

  • Kim, Insu
  • Kim, Minsoo
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This paper investigates the issue of rational expectations using inflation forecasts from the Survey of Professional Forecasters (SPF) and the Green Book. We provide an alternative test of rational expectations hypothesis by measuring the degree of persistence of potential systematic mistakes. The test is obtained by solving a signal extraction problem that distinguishes between systematic and non-systematic forecast errors. The findings indicate highly persistent systematic mistakes, which are driven by the inefficient use of available information, and reject the rational expectations hypothesis. The estimated time-varying bias can be used to improve the SPF and Green Book inflation forecast performance by at least 13.4%. This paper also documents evidence that the real interest rate plays a crucial role in explaining the level of bias that leads to under- and over predictions of actual inflation.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 16447.

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Date of creation: 23 Jul 2009
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Handle: RePEc:pra:mprapa:16447
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  1. Richard Clarida & Jordi Gali & Mark Gertler, 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," NBER Working Papers 6442, National Bureau of Economic Research, Inc.
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  13. David H. Romer & Christina D. Romer, 2000. "Federal Reserve Information and the Behavior of Interest Rates," American Economic Review, American Economic Association, vol. 90(3), pages 429-457, June.
  14. David Andolfatto & Scott Hendry & Kevin Moran, 2005. "Are Inflation Expectations Rational?," Macroeconomics 0501002, EconWPA.
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