P* Revisited: Money-Based Inflation Forecasts with a Changing Equilibrium Velocity

23 Pages Posted: 4 Feb 1999

See all articles by Athanasios Orphanides

Athanasios Orphanides

Massachusetts Institute of Technology (MIT) - Sloan School of Management; Asia School of Business

Richard D. Porter

Federal Reserve Bank of Chicago

Date Written: May 1998

Abstract

This paper implements recursive techniques to estimate the equilibrium level of M2 velocity and to forecast inflation using the P* model. The recursive estimates of equilibrium velocity are obtained by applying regression trees and least squares methods to a standard representation of M2 demand, namely a model in which the velocity of M2 depends on the opportunity cost of holding M2 instruments. Equilibrium velocity is defined as the level of velocity that would be expected to obtain if deposit rates were at their long-run average (equilibrium) value. We simulate the alternative models to obtain real-time forecasts of inflation and evaluate the performance of the forecasts obtained from the alternative models. We find that while a P* model assuming a constant equilibrium velocity does not provide accurate inflation forecasts in the 1990s, a model based on our time-varying equilibrium velocity estimates does quite well.

JEL Classification: E30, E50

Suggested Citation

Orphanides, Athanasios and Porter, Richard D., P* Revisited: Money-Based Inflation Forecasts with a Changing Equilibrium Velocity (May 1998). Federal Reserve Board FEDS Paper No. 98-26, Available at SSRN: https://ssrn.com/abstract=138469 or http://dx.doi.org/10.2139/ssrn.138469

Athanasios Orphanides (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-416
Cambridge, MA 02142
United States

HOME PAGE: http://mitsloan.mit.edu/faculty/detail.php?in_spseqno=54058

Asia School of Business ( email )

Jalan Kuching, Kuala Lumpur, Wilayah Persekutuan K
Kuala Lumpur, MA
Malaysia

Richard D. Porter

Federal Reserve Bank of Chicago ( email )

230 South LaSalle Street
Chicago, IL 60604
United States

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