Modelling Inflation Dynamics: A Critical Review of Recent Research

In recent years, a broad academic consensus has arisen around the use of rational expectations sticky-price models to capture inflation dynamics. These models are seen as providing an empirically reasonable characterization of observed inflation behavior once suitable measures of the output gap are chosen; and, moreover, are perceived to be robust to the Lucas critique in a way that earlier econometric models of inflation are not. We review the principal conclusions of this literature concerning: 1) the ability of these models to fit the data; 2) the importance of rational forward-looking expectations in price setting; and 3) the appropriate measure of inflationary pressures. We argue that existing rational expectations sticky-price models fail to provide a useful empirical description of the inflation process, especially relative to traditional econometric Phillips curves of the sort commonly employed for policy analysis and forecasting. ∗[email protected]. ∗∗[email protected]. An earlier draft of this paper was prepared for the FRB/JMCB Conference “Quantitative Evidence on Price Determination.” The views expressed are our own and do not necessarily reflect the views of the Board of Governors, the staff of the Federal Reserve System, or the Central Bank of Ireland. We thank Anne McGuinness for excellent research assistance. We are also grateful to our conference discussants, Laurence Ball and Bennett McCallum, for a number of useful comments.