Report

Trend inflation and inflation persistence in the New Keynesian Phillips curve

Abstract: The New Keynesian Phillips curve (NKPC) asserts that inflation depends on expectations of real marginal costs, but empirical research has shown that purely forward-looking versions of the model generate too little inflation persistence. In this paper, we offer a resolution of the persistence problem. We hypothesize that inflation is highly persistent because of drift in trend inflation, a feature that many versions of the NKPC neglect. We derive a version of the NKPC as a log-linear approximation around a time-varying inflation trend and examine whether it explains deviations of inflation from that trend. We estimate the NKPC parameters jointly with those that define the inflation trend by estimating a vector autoregression with drifting coefficients and volatilities; the autoregressive parameters are constrained to satisfy the restrictions imposed by the NKPC. Our results suggest that trend inflation has been historically quite volatile and that a purely forward-looking model that takes these fluctuations into account approximates well the short-run dynamics of inflation.

Keywords: Phillips curve; Inflation (Finance);

Bibliographic Information

Provider: Federal Reserve Bank of New York

Part of Series: Staff Reports

Publication Date: 2006

Number: 270