Article
Do We Know If Prices Are Forward Looking?
Working Paper
(2012)
Abstract
This paper reexamines the debate on the relative importance of forward
versus backward looking price-setting behavior in a hybrid Phillips curve
model. We first discuss the challenges in identifying the separate effects
of expected future inflation as opposed to lagged inflation. We then develop
a model where short run fluctuations in flexible-price-sector inflation
resemble measurement errors relative to the long-term-contract/core component
of inflation modeled in standard New Keynesian Phillips curves. The
measurement error perspective suggests that one should be careful to lag
instruments, in order to avoid correlations between the measurement errors
in lagged, current, and lead overall inflation and the measurement errors
in the instruments. When we do this, the estimated hybrid Phillips curve
tends to become significantly more backwards looking. To offset the decline
in instrument strength caused by lagging instruments for additional
periods, we find that expanding the instrument set by including alternative
inflation measures, such as the producer price index for finished goods, improves
identification of model parameters. The resulting estimates still point
to significantly more backward-looking behavior, implying that the share of
backward-looking firms may be close to one.
Disciplines
Publication Date
May, 2012
Citation Information
Qiang Zhang. "Do We Know If Prices Are Forward Looking?" Working Paper (2012) Available at: http://works.bepress.com/qiang_zhang/8/