Can Rational Expectations Sticky-Price Models Explain Inflation Dynamics?

Abstract

The canonical inflation specification in sticky-price rational expectations models (the new-Keynesian Phillips curve) is often criticized on the grounds that it fails to account for the dependence of inflation on its own lags. In response, many recent studies have employed a "hybrid" sticky-price specification in which inflation depends on a weighted average of lagged and expected future values of itself, in addition to a driving variable such as the output gap. In this paper, we consider some simple tests of the hybrid model that are derived from the model's closed-form solution. Our results suggest that the hybrid model provides a poor description of empirical inflation dynamics, and that there is little evidence of the type of rational forward-looking behavior implied by the model.

International Evidence on the New Keynesian Phillips Curve Using Aggregate and Disaggregate Data

“…IJP adopt this method and solve the forward‐looking term out of equation under the assumption that (quarterly) marginal costs follow an exogenous second‐order autoregressive process (AR(2)). This approach is related to the closed‐form solution approach that Rudd and Whelan (, , ) propose. Particularly, Rudd and Whelan obtain the closed‐form solution of the hybrid NKPC, which expresses inflation as a function of its own past value and a composite forward‐looking term of expected future marginal costs, and subsequently estimate it.…”

“…Fuhrer and Moore () and Linde () show that a full‐information approach has some advantages over GMM. Furthermore, the closed‐form solution approach is proposed by Rudd and Whelan (, , ), whereas inflation is expressed as a function of its own past value and a composite forward‐looking term of expected future marginal costs.…”

Estimation and Inference by the Method of Projection Minimum Distance: An Application to the New Keynesian Hybrid Phillips Curve*

“…Expression highlights a larger point that has, perhaps, received insufficient attention in the literature (some exceptions are Jondeau and Le Bihan, 2008; Mavroeidis, 2004; Rudd and Whelan, 2006): The validity of the instruments in GMM estimation is determined not by one's hypothesized model (in our case, expression ) but by the true data generating process (DGP), here expression . Since tractable macroeconomic models require parsimonious specifications in terms of dynamics and driving variables, it is important to assess the validity of candidate instruments for GMM estimation (MLE will be inconsistent due to misspecification, although the magnitude of the bias will differ from one application to the other).…”

Reference Norms, Staggered Wages, and Wage Leadership: Theoretical Implications and Empirical Evidence*

“…Nevertheless, the assumptions of automatic indexation and rule‐of‐thumb behavior are also controversial and they have been criticized as being ad hoc, implausible and at variance with the available evidence on actual price‐setting behavior of firms (cf. Mankiw and Reis, 2002; Rudd and Whelan, 2006). 2…”