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Stabilization and expectations in a state space model of interconnected economies, a dynamic panel study

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  • David Kiefer

Abstract

Carlin and Soskice (2005) advocate a 3-equation model of stabilization policy, the IS-PC-MR model. Their third equation is the monetary reaction rule MR derived by assuming that governments have performance objectives, but are constrained by an augmented Phillips curve PC. Central banks achieve their preferred outcome by setting interest rates along an IS curve. We simplify their model to 2 equations (PC and MR), developing a state space econometric specification of this solution, and adding a random walk model of unobserved potential growth. Applying this model to a panel of North Atlantic countries, we find it historically consistent with an inflation target of about 4%. Significant interdependence is found in the between-country covariance of inflation and growth shocks, but not of potential output. Beginning with the approximation that expected inflation is the most recent observation, we extend the model to introduce alternative assumptions about expectations with mixed results, support for the sticky-price model, but doubts about activist policy.

Suggested Citation

  • David Kiefer, 2011. "Stabilization and expectations in a state space model of interconnected economies, a dynamic panel study," Working Paper Series, Department of Economics, University of Utah 2011_15, University of Utah, Department of Economics.
  • Handle: RePEc:uta:papers:2011_15
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    References listed on IDEAS

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    More about this item

    Keywords

    new Keynesian policy; inflation targets; expectations JEL Codes: E61; E63;

    JEL classification:

    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy

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