Forward-looking versus backward-looking behavior in inflation dynamics: a new test

This paper contributes to the debate on inflation dynamics by proposing a novel method to test the relative importance of forward looking and backward-looking behavior. By using Galí and Gertler's (1999) New Keynesian hybrid model, I derive a dynamic structural relationship between the cross sectional variance of individual price changes and aggregate inflation. The parameters that determine the nature of price setting appear in this relationship and can be estimated. Three key advantages of this equation for estimation purposes are: i) it does not include measures of real marginal costs or output gap, which are very sensitive to different economic assumptions; ii) it does not require assumptions about how expectations are formed and iii) it directly identifies the structural parameters that describe the nature of the price setting. I estimate the proposed equation with Austrian and Spanish data. I find that inflation is far from being exclusively a forward looking phenomenon in these countries.