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Saturday, September 24, 2005

Do Sticky-Price RE Models Capture Inflation Dynamics Better Than Traditional Phillips Curve Models?

Generally, when presenting academic papers here I only present the abstract. However the subject of this paper is important enough to merit presenting more, so I am including the entire introduction, conclusion, and the extensive list of references. The issue is how well rational expectations sticky-price models capture inflation dynamics. The conclusion is that

...existing rational expectations sticky-price models fail to provide a useful empirical description of the inflation process, especially relative to traditional econometric Phillips curves of the sort commonly employed for policy analysis and forecasting.

which is not good news for advocates of the New Keynesian model.  Here's the paper by Rudd and Whelan that will be presented at this conference sponsored by the Federal Reserve Board and The Journal of Money, Credit, and Banking:

Modeling Inflation Dynamics: A Critical Survey of Recent Research, by Jeremy B. Rudd and Karl Whelan: 1 Introduction Robert Solow (1976) once observed that “any time seems to be the right time for reflections on the Phillips curve.” However, right now seems to present a particularly appropriate moment to take stock of the empirical evidence on inflation dynamics. Recent years have seen an explosion in empirical research on inflation, with most of it related to the so called “new-Keynesian” Phillips curve, which has provided a modern take on the traditional Phillips curve relationship by deriving it from an optimizing framework featuring rational expectations and nominal rigidities. That the current conference has taken its inspiration from the 1970 Federal Reserve conference on “The Econometrics of Price Determination” also seems appropriate because, like now, the 1970s witnessed an intense debate over the theoretical and empirical underpinnings of a popular econometric model of inflation. And, like now, these debates largely revolved around the merits of what appeared to be a new paradigm for understanding the behavior of inflation and the macroeconomy.1

In this paper, we offer a selective and critical review of recent developments in the theoretical and empirical modelling of U.S. inflation dynamics. We ... are not attempting to provide a comprehensive summary of the huge amount of research devoted to this topic ... Rather, we hope to shed light on a couple of key issues: first, how are inflation expectations formed; and second, what is an appropriate empirical measure of inflationary pressures. ... [O]ur survey will reflect the answers to these questions that we have proposed in our earlier work.2 In particular, our research has suggested a number of reasons to be skeptical about the new-Keynesian framework that is bidding to become the new benchmark model for inflation analysis. More generally, we discuss some reasons to doubt some of the stronger implications of the rational expectations hypothesis for the modelling of inflation. In that sense, our work connects back to many of the themes of the 1970 conference, and it is with those earlier debates that we begin.

We start by reviewing the origins of the Phillips curve and the debates over the accelerationist version of the model introduced by Friedman (1968) and Phelps (1967). We discuss the important critiques of econometric Phillips curves made by Sargent (1971) and Lucas (1972a), and trace how this led to the development of the modern “new-Keynesian” Phillips curve. We outline how, despite their apparent similarity, the accelerationist and new-Keynesian models turn out to have very different implications for monetary policy and for econometric modelling and forecasting.

The paper next provides an empirical assessment of the new-Keynesian Phillips curve. This is a structural model, designed to be capable of explaining the behavior of inflation without being subject to the Lucas critique, but it is well known that it generates extremely counterfactual predictions when traditional output gaps (based on naive detrending procedures) are used as a measure of inflationary pressures. However, in recent years it has become widely accepted that an alternative approach, which substitutes labor’s share of income in place of detrended output, is theoretically superior and yields a good empirical model of inflation dynamics. We argue that the theoretical case for this approach—which was advocated in an influential paper by Gali and Gertler (1999)—is quite weak, and that the labor’s share version of the new-Keynesian model actually provides a very poor description of observed inflation behavior. This failure of the model extends along two dimensions: first, labor’s share fails to provide a good measure of inflationary pressures; and second, this version of the model cannot account for the important role played by lagged inflation in empirical inflation regressions.

We also review the evidence relating to the so-called “hybrid” class of new-Keynesian models, which add a dependence of inflation on its own lagged values to otherwise purely forward-looking models. These models are often viewed as striking a compromise between the need for rigorous microfoundations of the sort underlying the pure new-Keynesian model and the need for reasonable empirical fit; thus, they have commonly been adopted for use in applied monetary policy analysis. Gali and Gertler’s conclusion that rational forward looking behavior plays the dominant role in these models is widely cited as a stylized fact in this literature. We provide an alternative interpretation of the empirical estimates obtained from these models, and argue that the data actually provide very little evidence of an important role for rational forward-looking behavior of the sort implied by these models. Finally, we end with a brief discussion of the properties of reduced-form econometric Phillips curves. The importance of lagged inflation in these models has led to them being criticized as being especially susceptible to the Lucas critique. As we show, however, this potential shortcoming of these models seems to be relatively unimportant in practice.

9 Conclusions The history of science provides many examples of theories that everyone knew were true, until they turned out to be false. At various points in history, intelligent people knew that the world was flat; knew that the sun revolved around the earth; and knew that there was an exploitable long-run tradeoff between inflation and  unemployment. Today, one can meet many researchers who know that the new-Keynesian Phillips curve provides a good model of the inflation process once one uses a suitable proxy for real marginal cost; who know that forward-looking rational behavior dominates price setting; and who know that the U.S. inflation process has fundamentally changed in the last twenty years because of a shift in how monetary policy has been conducted. We hope the evidence presented in this paper will give at least some interested researchers cause to check these conclusions more fully against the available evidence.

At the start of this paper, we posed two fundamental questions about inflation: first, what is a suitable measure of inflationary pressures; and second, how are inflation expectations formed. Regarding the former issue, we believe the evidence presented here militates strongly against the use of labor’s share of income as a useful proxy for inflationary pressures. In general, we find very little evidence for a strong link between inflation and current or expected values of this variable. Just as important to note in this context is the often forgotten fact that traditional output gaps remain highly significant predictors of inflation in reduced-form econometric regressions.

Regarding expectations formation, we do not wish to overstate the implications of these results for the merits of the rational expectations hypothesis. What we can say with some confidence is that the current class of popular rational expectations models fail to work well with either traditional output gaps or with labor’s share of income serving as a proxy for real marginal cost. But this does not rule out the possibility that the rational expectations approach might better fit the data with an alternative proxy for this hard-to-measure concept.

All that said, we believe there is little evidence that structural modelling of inflation in a rational expectations framework provides a clearly superior approach relative to traditional models of inflation dynamics. Reduced-form econometric models of inflation are surprisingly stable, and these models remain useful tools for forecasting. This may be because simple models of adaptive expectations, as described by Friedman and Phelps, still provide decent approximations to reality. Or it could instead be that existing rational expectations mechanisms do not capture the richness of how expectations are formulated in the real world. Further research on how expectations evolve and interact with the policy environment—such as recent work by Sargent (1999) and Orphanides and Williams (2005)—may well prove useful in advancing our understanding of these vital questions.

 

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1As Solow (1968, p. 3) also noted, “. . . the theory of inflation seems to make progress by way of a series of controversies. It is not uncommon for economics, or even for natural science, to proceed in this adversary manner, but I rather think it is especially characteristic of the analysis of inflation.”

2See Rudd and Whelan (2003), (2005a), and (2005b).

    Posted by on Saturday, September 24, 2005 at 12:43 AM in Academic Papers, Economics, Inflation, Macroeconomics, Unemployment | Permalink  TrackBack (0)  Comments (0)

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