The Formation of Inflation Expectations under Changing Inflation Regimes

Christian Dahl () and Niels L. Hansen ()
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Niels L. Hansen: Department of Economics, University of Aarhus, Denmark, Postal: 8000 Aarhus C, Denmark

Economics Working Papers from School of Economics and Management, University of Aarhus

Abstract: The present paper offers a careful description on empirical identification of possible multiple changes in regime. We apply recently developed tools designed to select between regime switching models among a broad class of linear and nonlinear regression models and provide a discussion on the impact on the formation of inflation expectations in the presence of multiple and recurrent changes in inflation regimes. Our empirical findings give a plausible explanation why the rational expectation hypothesis based on direct measures of inflation expectations from survey series is typically rejected due to large systematic differences between actual and expected inflation rates. In particular, our results indicate that in the case of changing and not perfectly observed inflation regimes, inference about rationality and unbiasedness based on a comparison of ex ante forecasts from survey series and actual inflation rate based on ex post realizations, will be ambiguous due to the presence of an ex post bias. The empirical findings are based on Danish inflation rates covering the period from 1957-1998. We show that it is not possible to reject the hypothesis of multiple inflationary regimes and that the actual inflation rate can be represented by a two state Markov regime switching model. It turns out that the real time forecasts produced from this model exhibit a large degree of similarity when compared to the direct measures of inflation expectations. The result illustrates the important impact of switching regimes on the formation of actual and expected inflation and hence of ex post bias as a main contributor to the difference between actual and expected inflation observed directly from survey series.

Keywords: Markov regime switching; ex post bias; inflation and inflation expectations (search for similar items in EconPapers)
JEL-codes: C14 C22 C42 C51 C52 C53 (search for similar items in EconPapers)
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