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The Predictive Content of the Output Gap for Inflation: Resolving In-Sample and Out-of-Sample Evidence

FRB of Kansas City Working Paper No. 03-06

54 Pages Posted: 15 Jun 2004  

Todd E. Clark

Federal Reserve Bank of Cleveland

Michael W. McCracken

Federal Reserve Banks - Federal Reserve Bank of St. Louis

Date Written: August 2003

Abstract

This paper sifts through explanations for the weakness of the out-of-sample evidence on the Phillips curve relative to the in-sample evidence, focusing on the output gap-based models. One explanation could be that, even when the model are stable, out-of-sample metrics are less powerful than in-sample Granger tests. The weakness of the out-of-sample evidence could also be due to model instability. This paper evaluates these explanations on the basis of comparisons of the sample forecasting results to results from Monte Carlo simulations of DGPs that either assume stability or allow breaks in the DGP. This analysis shows that most of the relative weakness in the out-of-sample evidence is attributable to model instabilities, particularly in the output gap coefficients. Theoretical analysis, based on a local alternatives framework, confirms that breaks in the output gap coefficients can lead to a breakdown in the power of tests of equal forecast accuracy and forecast encompassing.

Keywords: Phillips Curve, Forecasts, Causality, Break Test

JEL Classification: E37, E31, C53, C52

Suggested Citation

Clark, Todd E. and McCracken, Michael W., The Predictive Content of the Output Gap for Inflation: Resolving In-Sample and Out-of-Sample Evidence (August 2003). FRB of Kansas City Working Paper No. 03-06. Available at SSRN: https://ssrn.com/abstract=516422 or http://dx.doi.org/10.2139/ssrn.516422

Todd E. Clark (Contact Author)

Federal Reserve Bank of Cleveland ( email )

P.O. Box 6387
Cleveland, OH 44101
United States
216-579-2015 (Phone)

Michael W. McCracken

Federal Reserve Banks - Federal Reserve Bank of St. Louis ( email )

411 Locust St
Saint Louis, MO 63011
United States

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