Trend Inflation and Inflation Persistence in the New Keynesian Phillips Curve

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Staff Reports

Trend Inflation and Inflation Persistence in the New Keynesian Phillips Curve

December 2006 Number 270

JEL classification: E31

Authors: Timothy Cogley and Argia M. Sbordone

The New Keynesian Phillips curve (NKPC) asserts that inflation depends on expectations of real marginal costs, but empirical research has shown that purely forward-looking versions of the model generate too little inflation persistence. In this paper, we offer a resolution of the persistence problem. We hypothesize that inflation is highly persistent because of drift in trend inflation, a feature that many versions of the NKPC neglect. We derive a version of the NKPC as a log-linear approximation around a time-varying inflation trend and examine whether it explains deviations of inflation from that trend. We estimate the NKPC parameters jointly with those that define the inflation trend by estimating a vector autoregression with drifting coefficients and volatilities; the autoregressive parameters are constrained to satisfy the restrictions imposed by the NKPC. Our results suggest that trend inflation has been historically quite volatile and that a purely forward-looking model that takes these fluctuations into account approximates well the short-run dynamics of inflation.

Available only in PDF PDF

40 pages / 380 kb

For a published version of this report, see Timothy Cogley and Argia M. Sbordone, "Trend Inflation, Indexation, and Inflation Persistence in the New Keynesian Phillips Curve," American Economic Review98, no. 5 (December 2008): 2101-26.

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