Can Rational Expectations Sticky-Price Models Explain Inflation Dynamics?

• Published in: The American economic review Vol. 96; no. 1; pp. 303 - 320
• Main Authors: Rudd, Jeremy, Whelan, Karl
• Format: Journal Article
• Language: English
• Published: Nashville American Economic Association 01-03-2006
• Subjects: Central banks; Coefficients; Commodity prices; Economic dynamics; Economic models; Financial services; Generalized method of moments; Income shares; Inflation; Inflation rate; Keynesianism; Macroeconomics; Mathematical independent variables; Modeling; Monetary economics; Monetary models; Output gaps; Phillips curve; Rational expectations; Shorter Papers; Statistical significance; Sticky prices; Studies; Vector autoregression
• ISSN: 0002-8282; 1944-7981
• DOI: 10.1257/000282806776157560

The canonical inflation specification in sticky-price rational expectations models (the new-Keynesian Phillips curve) is often criticized for failing to account for the dependence of inflation on its own lags. In response, many studies employ a “hybrid” specification in which inflation depends on its lagged and expected future values, together with a driving variable such as the output gap. We consider some simple tests of the hybrid model that are derived from its closed form. We find that the hybrid model describes inflation dynamics poorly, and find little empirical evidence for the type of rational, forward-looking behavior that the model implies.