The Tradeoff between Inflation and the Real Economy: Forward-Looking Behavior and the Inflation Premium
43 Pages Posted: 14 Nov 2005
Date Written: November 10, 2005
We use the inflation premium - the difference between nominal and real interest rates - as a proxy for expected inflation in the context of the New Keynesian Phillips Curve. Using data from inflation-indexed and nominal bonds we estimate a forward-looking Phillips curve for the United Kingdom over the period 1985-2004. The proposed model describes UK inflation dynamics considerably better than does the standard hybrid New Keynesian Phillips Curve under the assumption of rational expectations. In contrast with the findings in the rest of the literature we find that there still exists a tradeoff between inflation and the stance of the real economy, regardless of the empirical measure used. This relationship also persists in the period since the UK adopted inflation targeting as a framework for monetary policy.
Keywords: Phillips curve, inflation expectations, inflation premium, tradeoff between inflation and aggregate demand, real and nominal bonds
JEL Classification: E31, E43
Suggested Citation: Suggested Citation