The role of inflation expectations in the EMU

Abstract

This article analyses the role of inflation expectations in the euro area. On the one hand, the question is how inflation expectations affect both inflation and output, and, on the other hand, how inflation expectations reflect developments in these variables. The analysis makes use of a simple VAR model of inflation, inflation expectations and output, which allows for scrutinizing the dynamic interrelationships between these variables. Empirical results strongly suggest that inflation expectations are the key ingredient of the inflationary process for the euro area and they have a significant negative effect on output. Inflation expectations are found to be relatively persistent – almost as persistent as output – albeit they do adapt to developments in both output and (actual) inflation, especially in the medium term.