Can Rational Expectations Sticky-Price Models Explain Inflation Dynamics?

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.

Introduction
In recent years, there has been a trend in macroeconomics toward analyzing business cycles and stabilization policy in the context of models that incorporate both nominal rigidities and optimizing agents with rational (i.e., model-consistent) expectations. One important way in which this “new-Keynesian” approach differs from earlier work in the Keynesian tradition involves the way in which expectations are assumed to aect price-setting behavior.

Author: Jeremy Rudd and Karl Whelan

Source: Lancaster University Management School

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