INFLATION DYNAMICS AND SUBJECTIVE EXPECTATIONS IN THE UNITED STATES

Abstract

I. INTRODUCTION This paper analyzes the ability of sticky-price models to explain the dynamics of U.S. inflation when using survey data as proxies for inflation expectations. Testing sticky-price models with survey expectations is attractive since, to the extent that survey data correctly capture agents' expectations, they allow to disregard issues related to the specification of agents' expectations functions. One neither has to impose untested orthogonality restrictions, as required when estimating under the assumption of rational expectations, nor has to make restrictive assumptions about the precise form of nonrationality present in agents' forecast functions. This allows to focus on the question whether the economic models under consideration are correctly specified. Previous tests of sticky-price models, performed under the assumption that agents hold rational expectations, have generated mixed results. Prominently, Fuhrer and Moore (1995) have reported that sticky-price models do not generate sufficient stickiness for inflation when the output gap is used as a measure of real marginal costs. Recent evidence, however, has shown that the empirical performance depends crucially on how one measures real marginal costs, the main determinant of inflation according to sticky-price models. For instance, Gall and Gertler (1999) and Sbordone (2002) show that sticky-price models perform well once marginal costs are approximated by average unit labor costs. (1) It makes an important difference whether sticky-price models successfully explain inflation dynamics as a function of output behavior or they relate inflation dynamics to the behavior of unit labor costs. Given that the ultimate objective is a model explaining the joint behavior of output and inflation, the latter case would require an additional empirically plausible theory linking the dynamics of unit labor costs to the behavior of output. This paper studies whether the currently popular New Keynesian Phillips Curve (NKPC), which can be derived from Calvo (1983) style sticky-price models, is able to explain a relationship between inflation on the one hand and output or unit labor costs on the other hand. Thus, we let the data speak whether a theory linking output to costs is warranted, once expectations are approximated by data reported in the Survey of Professional Forecasters. Our main finding is that the NKPC performs equally well with both measures of marginal costs, output and unit labor costs. Whatever measure is used, the estimate of the quarterly discount factor is close to one and the point estimate of the degree of price stickiness implies that firms reset their prices roughly every five quarters on average. These results suggest that potential nonrationalities in expectations, as they show up in surveys, have biased previous estimates using output as a measure for marginal costs. Quite surprisingly, the same nonrationalities do not seem to play a role when using unit labor costs. Here our estimates confirm the results obtained by Gall and Gertler (1999) and Sbordone (2002), who assumed rational expectations. We show that the reason for this finding is that approximating the agents' information set using the unit labor cost variable rests on more solid grounds than approximating it using the output variable. In particular, the survey data suggest that the hypothesis of rational expectations implies a too high correlation between lagged output and future inflation expectations. We show that this causes the coefficient estimate for output to become negative, contrary to what is implied by theory. These results suggest that once one takes account of potentially nonrational expectations via survey expectations, sticky-price models are able to establish a close link between output dynamics and the behavior of inflation. To assess the robustness of this finding, we include into the price equation lags of various variables and test for their significance. …