Working Papers

2004

 

August 2004, No. 04-6

The Output Gap, Expected Future Inflation and Inflation Dynamics: Another Look

Yash P. Mehra

The empirical test of the output gap-based New Keynesian Phillips curve often has been implemented by estimating a hybrid specification that includes both lagged and future inflation and then by examining whether the estimated coefficient on future inflation is significantly larger than the one on lagged inflation. This article presents the evidence that indicates supply shocks significantly enter the hybrid specification. The results reported in previous research — the output gap is irrelevant and expected future inflation is the major determinant of inflation — arise if the hybrid specification is estimated omitting supply shocks and/or lagged inflation. In the hybrid specification estimated with supply shocks, the output gap is significant. The estimated coefficient on future inflation is quantitatively small, but the estimated coefficient on lagged inflation is significantly larger than the one on future inflation. The null hypothesis that the estimated coefficient on lagged inflation is unity is not rejected if the hybrid specification nests an alternative version of the traditional Phillips curve in which inflation responds also to a change in the output gap. Together these results suggest that expected future inflation is not the major determinant of current inflation.

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