Scientific Monographs, Bank of Finland
No E:32/2005:
The role of expectations in euro area inflation dynamics
Maritta Paloviita ()
Abstract: This paper examines empirical performance of three
different Phillips curve specifications in the euro area. Instead of
imposing rational expectations, direct measures, ie OECD forecasts, are
used to proxy economic agents’ inflation expectations. Real marginal costs
are measured in three different ways. The results suggest that with
directly measured expectations the estimated New Classical Phillips curve
has satisfactory statistical properties. Moreover, the driving variable
enters the estimated, purely forward-looking, New Keynesian Phillips curve
with the correct sign, but it is clearly outperformed by the New Classical
and Hybrid Phillips curves. We interpret our results as indicating that the
European inflation process is not purely forward-looking, so that inflation
cannot instantaneously adjust to new information. Consequently, even
allowing for possible non-rationality in expectations, a lagged inflation
term enters the New Keynesian Phillips curve for European inflation
dynamics. The inflation process seems to have become more forward-looking
in the recent years of low and stable inflation. Furthermore, in the New
Keynesian Phillips curve relationship, the output gap turns out to be at
least as good a proxy for real marginal cost as is the labour income
share.
Keywords: Phillips curve; expectations; euro area; (follow links to similar papers)
JEL-Codes: C52; E31; (follow links to similar papers)
95 pages, August 29, 2005
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