Modeling heterogeneous inflation expectations: empirical evidence from demographic data?

Abstract

This study proposes the Idiosyncratic Adaptive Expectation model based on decision theory to explain how agents incorporate information about the past to form their inflation expectations. The empirical results suggest that both inflation perception and past actual inflation have significant effects on the formation of inflation expectations, and the Idiosyncratic Adaptive Expectation model is valid in capturing the dynamics of inflation expectations. Investigations of demographic groups provide robust supportive evidence for this novel model. The results suggest that agents are more concerned about inflation perception, which is less costly to understand, than about actual inflation, which entails higher costs. Furthermore, the Granger causality test reveals that more heterogeneous inflation perceptions cause statistically higher heterogeneity in inflation expectations. Compared with rational expectation, adaptive expectation, static expectation and idiosyncratic static expectation models, the Idiosyncratic Adaptive Expectation model is better at capturing inflation expectations empirically. The results have implications for macroeconomic modeling, stressing the significance of perceived and expected inflation.