Modelling Inflation Dynamics: A Critical Review of Recent Research

In recent years, a broad academic consensus has arisen around the use of rational expectations sticky-price models to capture inflation dynamics. These models are seen as providing an empirically reasonable characterization of observed inflation behavior once suitable measures of the output gap are chosen; and, moreover, are perceived to be robust to the Lucas critique in a way that earlier econometric models of inflation are not. We review the principal conclusions of this literature concerning: 1) the ability of these models to fit the data; 2) the importance of rational forward-looking expectations in price setting; and 3) the appropriate measure of inflationary pressures. We argue that existing rational expectations sticky-price models fail to provide a useful empirical description of the inflation process, especially relative to traditional econometric Phillips curves of the sort commonly employed for policy analysis.