Inflation in the G7: Mind the Gap(s)?

Federal Reserve Bank of St. Louis Bank Working Paper No. 2011-011A

42 Pages Posted: 23 Apr 2011

See all articles by James Morley

James Morley

University of Sydney

Jeremy Piger

University of Oregon - Department of Economics

Robert Rasche

Michigan State University; National Bureau of Economic Research (NBER)

Date Written: April 20, 2011

Abstract

We investigate the importance of trend inflation and the real-activity gap for explaining observed inflation variation in G7 countries since 1960. Our results are based on a bivariate unobserved-components model of inflation and unemployment in which inflation is decomposed into a stochastic trend and transitory component. As in recent implementations of the New Keynesian Phillips Curve, it is the transitory component of inflation, or "inflation gap", that is driven by the real-activity gap, which we measure as the deviation of unemployment from its natural rate. Even when allowing for changes in the contributions of trend inflation and the inflation gap, we find that both are important determinants of inflation variation at business cycle horizons for all G7 countries throughout much of the past 50 years. Also, the real-activity gap explains a large fraction of the variation in the inflation gap for each country, both historically and in recent years. Taken together, the results suggest the New Keynesian Phillips Curve, once augmented to include trend inflation, is an empirically relevant model for the G7 countries. We also provide new estimates of trend inflation for the G7 that incorporate information in the real-activity gap for identification and, through formal model comparisons, new statistical evidence regarding structural breaks in the variability of trend inflation and the inflation gap.

Keywords: inflation gap, inflation persistence, natural rate, Phillips Curve, trend inflation

JEL Classification: C32, E31, E32

Suggested Citation

Morley, James and Piger, Jeremy M. and Rasche, Robert, Inflation in the G7: Mind the Gap(s)? (April 20, 2011). Federal Reserve Bank of St. Louis Bank Working Paper No. 2011-011A. Available at SSRN: https://ssrn.com/abstract=1816745 or http://dx.doi.org/10.2139/ssrn.1816745

James Morley

University of Sydney ( email )

Rm 370 Merewether (H04)
Sydney, NSW 2006 2008
Australia

HOME PAGE: http://https://sites.google.com/site/jamescmorley/

Jeremy M. Piger

University of Oregon - Department of Economics ( email )

Eugene, OR 97403
United States

Robert Rasche (Contact Author)

Michigan State University ( email )

East Lansing, MI 48824
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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