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Inflation dynamics in the euro area and the role of expectations

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  • Maritta Paloviita

    (Bank of Finland)

Abstract

This paper assesses empirically the two main alternative specifications of the output gap-based Phillips relation for the euro area: the older expectations-augmented Phillips curve and the new Keynesian Phillips curve. The main focus is on the role of expectations and comparison of the two theories. Instead of imposing rational expectations, an alternative and in principle less restrictive approach is applied to operationalising expectations. Direct measures of inflation expectations, ie OECD forecasts, are used as empirical proxies of economic agents’ inflation expectations. The main interest is in the euro area as a whole, although potential heterogeneity of inflation dynamics is also examined across eleven EMU countries. According to the results, inflation expectations are central to the inflation process in all euro area countries. The paper finds evidence that the new Keynesian Phillips curve fits the euro area data slightly better than the expectations-augmented Phillips curve. Research on expectations formation would be an important complement to the present study.

Suggested Citation

  • Maritta Paloviita, 2004. "Inflation dynamics in the euro area and the role of expectations," Macroeconomics 0405015, EconWPA.
  • Handle: RePEc:wpa:wuwpma:0405015
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    References listed on IDEAS

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    3. Benigno, Pierpaolo & Lopez-Salido, J. David, 2006. "Inflation Persistence and Optimal Monetary Policy in the Euro Area," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(3), pages 587-614, April.
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    Cited by:

    1. Männistö, Hanna-Leena, 2005. "Forecasting with a forward-looking DGE model : combining long-run views of financial markes with macro forecasting," Research Discussion Papers 21/2005, Bank of Finland.
    2. Paloviita, Maritta, 2005. "The role of expectations in euro area inflation dynamics," Scientific Monographs, Bank of Finland, number 2005_032, November.
    3. Arnold, Ivo J.M. & Soederhuizen, Beau, 2016. "Internal or external devaluation? What does the EC Consumer Survey tell us about macroeconomic adjustment in the Euro area?," Journal of International Money and Finance, Elsevier, vol. 64(C), pages 88-103.

    More about this item

    Keywords

    Phillips curve; expectations; euro area;

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection

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