Self-Fulfilling Inflation Inertia under Model Uncertainty
68 Pages Posted: 7 May 2009
Date Written: May 6, 2009
It is well known that the canonical New Keynesian model cannot produce inflation inertia observed in real data. The purpose of this research is to investigate expectation formation process as a potential source of inflation inertia. We examine a purely forward-looking New Keynesian Phillips curve with heterogeneous expectations, where the coordination of agents' beliefs matters. Private agents with heterogeneous beliefs are assumed to choose from a list of potentially misspecified econometric models and base their selections on relative forecast performance. When the distribution of heterogeneity is allowed to vary, there exist multiple equilibria: rational expectations equilibrium without any inertia and misspecification equilibrium with inertia. This inertia does not come from any structural components, such as a backward-looking behavior of price-setters, but from the expectation formation process of the private agents. In this sense, the inflation inertia in our model can be viewed as a self-fulfilling prophecy of the private agents. We then combine model selection with the adaptive learning, through which the agents update the parameters of their models. Our simulations show that convergences toward both equilibria are possible and the quality of initial knowledge has long-standing effect on the economy.
Keywords: New Keynesian Model, Inertia, Heterogeneous Expectation, Dynamic Predictor Selection, Coordination, Self-Fulfilling Prophecy
JEL Classification: E52, E58, D83
Suggested Citation: Suggested Citation