Decomposing the Output Gap with Inflation Learning
33 Pages Posted: 6 Apr 2021 Last revised: 24 May 2021
Date Written: May 23, 2021
We incorporate adaptive learning-based inflation expectations in an Unobserved Components model in order to study the link between inflation and the output gap. The forward-looking New Keynesian Phillips curve serves as the backbone for modeling inflation dynamics. We find that learning based inflation forecasts not only shadow survey expectations in the pre-Volcker era, they also do not exhibit the persistent overshooting during the initial stages of the financial crisis that is seen with surveys. The resulting output gap from our model has a lower amplitude than the gap estimated using survey expectations in the post 1984 sample. The interesting learning dynamics around business cycle turning points indicate that several recessions, including the recent Great Recession, were at least partially driven by large drops in the trend component of output.
Keywords: Adaptive Learning, Output Gap, Inflation, Unobserved Components Model
JEL Classification: E31, E32, E50, C32
Suggested Citation: Suggested Citation