Abstract
We formulate a dynamic AD-AS model based on gradually adjusting wages and prices, perfect foresight of current inflation rates and adaptive expectations concerning the inflation climate in which the economy operates. The model consists of a wage and a price Phillips curve, a dynamic IS curve as well as a dynamic employment adjustment equation (Okun's law) and a Taylor interest rate rule. The model can be reduced to a 3D dynamical system by a suitable choice of the Taylor rule and implies strong stability results, in particular for an appropriately chosen interest rate policy rule. Through instrumental variables GMM system estimation with aggregate time series data for the U.K. economy, we obtain parameter estimates which support the specification of our theoretical model and its stability implications. We contrast these results with the standard (formally similarly structured) New Keynesian model with staggered wage and price setting where determinacy of the dynamics represents a severe problem and where (if determinacy can be achieved) inertia-free stability is obtained by the very choice of the solution method.
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