New Tests of the New-Keynesian Phillips Curve

Abstract

Is the observed correlation between current and lagged inflation a function of backward-looking inflation expectations, or do the lags in inflation regressions merely proxy for rational forward-looking expectations, as in the newKeynesian Phillips curve? Recent research has attempted to answer this question by using instrumental variables techniques to estimate "hybrid" specifications for inflation that allow for effects of lagged and future inflation. We show that these tests of forward-looking behavior have very low power against alternative, but non-nested, backward-looking specifications, and demonstrate that results previously interpreted as evidence for the new-Keynesian model are also consistent with a backward-looking Phillips curve. We develop alternative, more powerful tests, which find a very limited role for forward-looking expectations. JEL classification code: E31

Has the inflation process changed?

“…10 These results highlight the importance of controlling for mean breaks when estimating persistence, as well as the critical role played by the choice of sample period. If one does not allow for any break in the mean, then aggregate inflation persistence tends to be higher and close to one, as has been found previously (e.g., Fuhrer and Moore, 1995;Rudd and Whelan, 2001). However, allowing for even one 10 Note that we do have a long run of data for the aggregate inflation series for Austria, Belgium, France, Germany, Italy and Spain, but do not have a long time series of the components for any of these countries except Spain.…”

“…This aspect of these models has been criticized by, inter alia , Ball (1994), Fuhrer and Moore (1995) and Rudd and Whelan (2001). Ball (1994) pointed out that traditional time-dependent models imply that (credible) disinflations are costless, and, in some cases, can even be associated with a boom in output.…”

Derivation and Estimation of a New Keynesian Phillips Curve in a Small Open Economy

“…5 In addition, there is a risk of misleading results in case of speci…cation errors in the estimated equation, as pointed out by Rudd and Whelan (2001). Assume that the true model for in ‡ation includes only lags of in ‡ation -as is often the case in empirical in ‡ation equations -and no forward looking component.…”

A reappraisal of the inflation–unemployment tradeoff

“…This shock is unanticipated and may be interpretted as a single realization of the stochastic process generating the money supply. 53 We derive the inflation and unemployment responses to this shock for time t ≥ 0.…”

“…The analogous restriction is imposed on the wage equation. 53 Since the shock is a realization of the actual money growth process, this exercise does not run afoul of the Lucas critique. 54 We assume that the future values of the exogenous variables are unaffected by the monetary shock (which is obvious, for otherwise these variables would not be exogenous).…”