The ( Un ) Importance of Forward-Looking Behavior in Price Specifications

The seminal work of Edmund S. Phelps (1978), John B. Taylor (1980), and Guillermo A. Calvo (1983) developed forward-looking models of price determination that imparted inertia to the price level. These models incorporate expectations of future prices and excess demand by imposing constraints (typically lag-lead symmetry constraints) that force future variables to enter the specification. In this paper, the author tests the empirical significance of future prices in specifications like those of Taylor. He finds that expectations of future prices are empirically unimportant in explaining price and inflation behavior. However, the dynamics of a model that includes a purely backward-looking inflation specification differ substantially--and not altogether pleasingly--from those with a forward-looking specification. Copyright 1997 by Ohio State University Press.

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