Working Paper

A Financial New Keynesian Model

Abstract: This paper solves a standard New Keynesian model in terms of risk-neutral expectations and estimates it using a cross-section of longer-dated financial assets at a single point in time. Inflation risk premia appear in the theory and cause inflation to deviate from its target on average. We re-estimate the model based on each day’s closing prices to capture high-frequency changes in the expected path of the economy. Our estimates show that financial markets reacted to the post-COVID surge in inflation with higher short-run inflation expectations, an increase in the inflation risk premium, and an increase in the long-run neutral real rate, 𝑟∗, while long-term inflation expectations remained well anchored. Our model produces long term inflation forecasts that outperform several standard alternative measures.

Keywords: Keynesian models; financial markets; covid19; inflation forecasts;

https://doi.org/10.24148/wp2023-35

Bibliographic Information

Provider: Federal Reserve Bank of San Francisco

Part of Series: Working Paper Series

Publication Date: 2023-11-13

Number: 2023-35

Pages: 49