Does theory aid in ‡ation forecasting? To address this question, we develop a novel forecasting procedure based upon a New Keynesian Phillips Curve that incorporates time-varying trend in ‡ation, to capture shifts in central bank preferences and monetary policy frameworks. We generate theory-implied predictions for both the trend and cyclical components of in ‡ation, and recombine them to obtain an overall in ‡ation forecast. Using quarterly data for the Euro Area and the United States that cover almost half a century, we compare our in ‡ation forecasting procedure against the most popular time series models. We …nd that our theorybased forecasts outperform these benchmarks that previous studies found di¢ cult to beat. Our results are shown to be robust to structural breaks, geographic areas, and variants of the econometric speci…cation. Our …ndings suggest that the skepticism concerning the use of theory in forecasting is unwarranted, and theory should continue to play an important role in policymaking.
This paper presents a two-country sticky-price model that allows for capital and investment spending. It analyzes the conditions for equilibrium determinacy under alternative interest-rate rules that react to either domestic or consumer price inflation. It is shown that in the presence of investment, real indeterminacy is considerably easier to obtain once trade openness is permitted. Consequently we argue that sufficiently open economies should adopt a backward-looking rule and sufficiently closed economies should employ a current-looking rule, in order to minimize policy induced aggregate instability.
This paper uses Bayesian estimation techniques to uncover the central bank preferences of the big …ve Latin American in ‡ation targeting countries: Brazil, Chile, Colombia, Mexico, and Peru. The target weights of each central bank's loss function are estimated using a medium-scale small open economy New Keynesian model with incomplete international asset markets and imperfect exchange-rate pass-through. Our results suggest that all central banks in the region place a high priority on stabilizing in ‡ation and interest rate smoothing. While stabilizing the real exchange rate is a concern for all countries except Brazil, only Mexico is found to assign considerable weight to reducing real exchange rate ‡uctuations. Overall, Brazil, Colombia, and Peru show evidence of implementing a strict in ‡ation targeting policy, whereas Chile and Mexico follow a more ‡exible policy by placing a sizeable weight to output gap stabilization. Finally, the posterior distributions for the central bank preference parameters are found to be strikingly di¤erent under complete asset markets. This highlights the sensitivity of Bayesian estimation, particularly when uncovering central bank preferences, to alternative international asset market structures.
Should central banks target consumer price inflation (CPI) in the setting of monetary policy, as has been orthodoxy in most of the developed world since the 1990s? Several prominent recent studies have argued against this, based on the finding that targeting CPI can make expectations of higher consumer prices self‐fulfilling. If the central bank responds to an extrinsic‐shock‐driven rise in CPI expectations by driving up the real interest rate, the argument goes, the resulting improvement in the terms of trade can increase consumer prices even if producer prices fall. These studies are, however, based on a flawed assumption that what motivates current transactions is the money consumers have after leaving the goods market. Using what is shown to be the more defensible assumption that such transactions are motivated by the money consumers have before entering the goods market, this paper demonstrates that targeting CPI helps to prevent self‐fulfilling expectations. This is because an improvement in the terms of trade now serves to exert downward pressure on CPI, irrespective of the response of producer prices. Consequently, the initial rise in CPI expectations is not self‐fulfilling under CPI targeting, whereas under producer price inflation (PPI) targeting, improvements in the terms of trade act as an undesirable negative cost shock. Central banks in open economies would therefore be ill‐advised to shift from CPI to PPI targeting, as the latter is more likely to result in welfare‐reducing, self‐fulfilling expectations.
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