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We construct a measure of global liquidity using the growth rates of broad money for the G7 economies. Global liquidity produces forecasts of U.S. inflation that are significantly more accurate than the forecasts based on U.S. money growth, Phillips curve, and autoregressive and moving average models. The marginal predictive power of global liquidity is strong at 3-year horizons. Results are robust to alternative measures of inflation. JEL codes: C22, C53, E37, E47 Keywords: predictive accuracy, global liquidity, money growth, inflation., ACCURATE INFLATION FORECASTS are essential for successful monetary policymaking. Effective predictors are essential for producing accurate forecasts. In the recent past, characterized by low and stable inflation, researchers in academia [...]

In this paper, I provide a plausible explanation as to why past studies have been unable to find support for the long-run Fisher effect. My argument is that exogenous shocks to the inflation rates in industrialized economies have not produced the permanent change to inflation necessary for testing the Fisher effect. Instead of finding a nonstationary, unit-root process for inflation like previous Fisher effect studies, here each country's inflation rate is found to follow a mean-reverting, fractionally integrated, long-memory process. Applying a bivariate, maximum likelihood estimator to a multivariate, fractionally integrated model of inflation and nominal interest, I find that the estimated inflation rates in 17 developed countries are highly persistent, fractionally integrated, mean-reverting processes with order of integration parameters significantly less than one. Since a permanent change to inflation has not occurred, a test of whether a permanent change to inflation affects the nominal interest rate one-for-one will be uninformative as to the truth or fallacy of the Fisher effect hypothesis. JEL code: E43 Keywords: Fisher effect, long memory, fractional integration., THE LONG-RUN Fisher effect hypothesis states that a permanent change to inflation will cause nominal interest rates to move one-for-one with the change in inflation, thus leaving the real interest [...]

It has become customary to estimate the New Keynesian Phillips Curve (NKPC) with generalized method of moments using a large instrument set that includes lags of variables that are ad hoc to the firm's price-decision problem. Researchers have also conventionally used real unit labor cost (RULC) as the proxy for real marginal cost even though it is difficult to support its significance. This paper introduces a new proxy for the real marginal cost term as well as a new instrument set, both of which are based on the micro foundations of the vertical chain of production. I find that the new proxy, based on input prices as opposed to wages, provides a more robust and significant fit to the model. Instruments that are based on the vertical chain of production appear to be both more valid and relevant toward the model. JEL codes: C2, C5, E3, E5 Keywords: New Keynesian Phillips Curve, generalized method of moments, vertical production chain, inflation., THE NEW KEYNESIAN PHILLIPS CURVE (NKPC) has become the backbone of current macroeconomic inflation research. The model's prominence resides in its simple structure yet micro-founded principles whereby firms make their [...]

The New Keynesian Phillips Curve (NKPC) model of inflation dynamics based on forward-looking expectations is of great theoretical significance in monetary policy analysis. Empirical studies, however, often find that backward-looking inflation inertia dominates the dynamics of the short-run aggregate supply curve. This inconsistency is examined by investigating multiple structural changes in the NKPC for the U.S. between 1960 and 2005, employing both inflation expectations survey data and a rational expectations approximation. We find that forward-looking behavior plays a smaller role during the high and volatile inflation regime to 1981 than in the subsequent period of moderate inflation, providing empirical support for sticky price models over the last two decades. A break in the intercept of the NKPC is also identified around 2001 and this may be associated with U.S. monetary policy in that period. JEL codes: E31, E37, E52, E58 Keywords: New Keynesian Phillips Curve, inflation survey forecasts, sticky prices, structural breaks, monetary policy., The theories usually stop short, however, of specifying models of aggregate supply that are intended to hold generally. --David Romer Advanced Macroeconomics, 2006, p. 257 RECENT EMPIRICAL STUDIES of the [...]

The rise and fall of inflation during the Great Inflation were events of approximately equal duration in developed economies. Relying on data-driven methods, this paper shows the American experience, in which inflation fell more quickly than it rose, was anomalous. This suggests that theories explaining the asymmetry in the American data may not be so applicable to a broader sample of countries. JEL code: E52 Keywords: Great Inflation, asymmetry., DURING THE GREAT INFLATION, inflation rose over a longer period than it fell in the United States. This asymmetry has been widely noted in the literature and is one target [...]

In this paper we provide a theoretical treatment of how inflation target ranges cope with the time-inconsistency problem arising from incentives for the monetary policymaker to exploit the short-run trade-off between employment and inflation to pursue short-run employment objectives, as in a Barro-Gordon (1983) model. Inflation band targets are able to achieve many of the benefits that arise under practically less attractive solutions such as the conservative central banker and optimal inflation contracts. Our theoretical model also shows how an inflation targeting range should be set and how it should respond to changes in the nature of shocks to the economy. JEL codes: E52, E58 Keywords: discretionary policy, inflation band targeting, inflation contracts, time-inconsistency., WITH THE DEVELOPMENT of the literature on the time-inconsistency problem in Kydland and Prescott (1977), Calvo (1978), and Barro and Gordon (1983), there has been an increasing recognition both by [...]

We argue that the empirical failure of the Fisher effect found in the literature may be due to the existence of non-linearities in the long-run relationship between interest rates and inflation. We present evidence that, for the U.S. during the 1960-2004 period, the Fisher relation presents important non-linearities. We model the long-run non-linear relationship and find that an ESTR model for the pre-Volcker era and an LSTR model for the post-Volcker era are able to control for non-linearities and constitute long-run co-integration vectors. Monte Carlo evidence produces support for the hypothesis that non-linearities may also be responsible for the less than proportional coefficients of inflation usually found in the linear specifications. JEL codes: E43, C32 Keywords: Fisher effect, non-linearities, co-integration., THE FISHER EQUATION that relates nominal interest rates and expected inflation forms part of the core of macroeconomic analysis. A full Fisher effect in the long run would imply monetary [...]

A policy maker knows two models. One implies an exploitable inflation-unemployment trade-off, the other does not. The policy maker's prior probability over the two models is part of his state vector. Bayes' law converts the prior probability into a posterior probability and gives the policy maker an incentive to experiment. For models calibrated to U.S. data through the early 1960s, we compare the outcomes from two Bellman equations. The first tells the policy maker to 'experiment and learn.' The second tells him to 'learn but don't experiment.' In this way, we isolate a component of government policy that is due to experimentation and estimate the benefits from intentional experimentation. We interpret the Bellman equation that learns but does not intentionally experiment as an 'anticipated utility' model and study how well its outcomes approximate those from the 'experiment and learn' Bellman equation. The approximation is good. For our calibrations, the benefits from purposeful experimentation are small because random shocks are big enough to provide ample unintentional experimentation. JEL codes: C11, C61, E58 Keywords: learning, model uncertainty, Bayes' law, intentional experimentation, Phillips curve, opportunism, Bayesian analysis, optimization techniques, programming models, dynamic analysis, central banks and their policies., 1.1 An Incentive to Experiment THIS PAPER STUDIES a classic problem in which a single decision maker confronts model uncertainty. (1) A central banker has two models of the Phillips [...]

Most central banks perceive a trade-off between stabilizing inflation and stabilizing the gap between output and desired output. However, the standard new Keynesian framework implies no such trade-off. In that framework, stabilizing inflation is equivalent to stabilizing the welfare-relevant output gap. In this paper, we argue that this property of the new Keynesian framework, which we call the divine coincidence, is due to a special feature of the model: the absence of nontrivial real imperfections. We focus on one such real imperfection, namely, real wage rigidities. When the baseline new Keynesian model is extended to allow for real wage rigidities, the divine coincidence disappears, and central banks indeed face a trade-off between stabilizing inflation and stabilizing the welfare-relevant output gap. We show that not only does the extended model have more realistic normative implications, but it also has appealing positive properties. In particular, it provides a natural interpretation for the dynamic inflation-unemployment relation found in the data. JEL codes: E32, E50 Keywords: oil price shocks, inflation targeting, monetary policy, inflation inertia., A STANDARD NEW Keynesian (NK) model has emerged. On the supply side, it consists of Calvo price and/or wage staggering. On the demand side, it is composed of an Euler [...]