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Long‐term inflation expectations and inflation dynamics

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  • Thórarinn G. Pétursson

Abstract

After rising sharply following the Global Financial Crisis, inflation in Iceland has been low and stable in recent years despite a strong cyclical recovery. This not only reflects favourable external conditions but also coincides with a significant decline in long‐term inflation expectations in financial markets. It is argued, however, that this market‐based measure of inflation expectations actually underestimates the true decline in long‐term inflation expectations of price setters. To extract this unobserved wedge between inflation expectations of price setters and financial agents, we estimate a time‐varying parameter Phillips curve model for the inflation‐targeting period since 2001, adjusting also for an unobserved risk premium in market‐based inflation expectations. The empirical results suggest that the expectations wedge was significantly positive until early 2012, after which it starts to gradually decline towards zero. The true decline in long‐term inflation expectations of actual price setters is, therefore, much steeper than is captured by the market‐based measure and taking this into account results in a stable and plausible specification of the Phillips curve that can explain key features of the recent inflation developments in Iceland.

Suggested Citation

  • Thórarinn G. Pétursson, 2022. "Long‐term inflation expectations and inflation dynamics," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 27(1), pages 158-174, January.
    • Handle: RePEc:wly:ijfiec:v:27:y:2022:i:1:p:158-174
    DOI: 10.1002/ijfe.2144
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    More about this item

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation: Models and Applications
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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