The New-Keynesian Phillips Curve and Inflation Persistence

The New-Keynesian Phillips curve is usually reported to fit the data better when lagged inflation, and therefore backward-looking price setting, is included in the equation. We argue that the same inflation persistence can be generated by letting the shocks in the economy be highly correlated in a model where price setting is purely forward-looking. Previous estimates in the literature are biased towards backward-looking price setting because of the existence of a unit root in the inflation data. Estimates of the New Phillips curve that take these factors into account reject backward-looking price setting in favor of highly correlated shocks. ∗christian [email protected] †I wish to thank Ben McCallum and Tom Tallarini for valuable comments and suggestions.