Scientific Monographs, Bank of Finland
No E:40/2009:
Dynamics of inflation expectations in the euro area
Maritta Paloviita ()
Abstract: The present study examines empirically the inflation
dynamics of the euro area. The focus of the analysis is on the role of
expectations in the inflation process. In six articles we relax rationality
assumption and proxy expectations directly using OECD forecasts or
Consensus Economics survey data. In the first four articles we estimate
alternative Phillips curve specifications and find evidence that inflation
cannot instantaneously adjust to changes in expectations. A possible
departure of expectations from rationality seems not to be powerful enough
to totally explain the persistence of euro area inflation in the New
Keynesian framework. When expectations are measured directly, the purely
forward-looking New Keynesian Phillips curve is outperformed by the hybrid
Phillips curve with an additional lagged inflation term and the New
Classical Phillips curve with a lagged expectations term. The results
suggest that the euro area inflation process has become more
forward-looking in the recent years of low and stable inflation. Moreover,
in low inflation countries, the inflation dynamics have been more
forward-looking already since the late 1970s. We find evidence of
substantial heterogeneity of inflation dynamics across the euro area
countries. Real time data analysis suggests that in the euro area real time
information matters most in the expectations term in the Phillips curve and
that the balance of expectations formation is more forward- than
backward-looking. Vector autoregressive (VAR) models of actual inflation,
inflation expectations and the output gap are estimated in the last two
articles. The VAR analysis indicates that inflation expectations, which are
relatively persistent, have a significant effect on output. However,
expectations seem to react to changes in both output and actual inflation,
especially in the medium term. Overall, this study suggests that
expectations play a central role in inflation dynamics, which should be
taken into account in conducting monetary policy.
Keywords: inflation expectations; Phillips curve; vector autoregressive models; euro area; (follow links to similar papers)
JEL-Codes: C52; E31; (follow links to similar papers)
61 pages, January 15, 2009
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