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A New Model of Trend Inflation

Author

Listed:
  • Joshua Chan

    (College of Business and Economics, Australian National University)

  • Gary Koop

    (Department of Economics, University of Strathclyde)

  • Simon Potter

    (Federal Reserve Bank of New York)

Abstract

This paper introduces a new model of trend (or underlying) inflation. In contrast to many earlier approaches, which allow for trend inflation to evolve according to a random walk, ours is a bounded model which ensures that trend inflation is constrained to lie in an interval. The bounds of this interval can either be fixed or estimated from the data. Our model also allows for a time-varying degree of persistence in the transitory component of inflation. The bounds placed on trend inflation mean that standard econometric methods for estimating linear Gaussian state space models cannot be used and we develop a posterior simulation algorithm for estimating the bounded trend inflation model. In an empirical exercise with CPI inflation we find the model to work well, yielding more sensible measures of trend inflation and forecasting better than popular alternatives such as the unobserved components stochastic volatility model.

Suggested Citation

  • Joshua Chan & Gary Koop & Simon Potter, 2012. "A New Model of Trend Inflation," Working Papers 1202, University of Strathclyde Business School, Department of Economics.
    • Handle: RePEc:str:wpaper:1202
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    References listed on IDEAS

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    1. repec:acb:camaaa:2012-13 is not listed on IDEAS
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    Keywords

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    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation: Models and Applications
    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods

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