The Output Gap, Expected Future Inflation and Inflation Dynamics: Another Look

Abstract The empirical test of the New Keynesian Phillips curve is often implemented by estimating a hybrid specification that includes both lagged and future inflation and then by examining whether the estimated coefficient on future inflation is significantly larger than the one on lagged inflation. This article presents evidence that supply shocks matter. Results in previous research – the output gap is irrelevant and expected future inflation is the major determinant of inflation – arise if the hybrid specification is estimated omitting supply shocks and/or lagged inflation. With supply shocks included, the output gap is significant and the estimated coefficient on lagged inflation is significantly larger than the one on future inflation. The estimated coefficient on lagged inflation is unity if in the hybrid specification inflation responds also to a change in the output gap. Together these results suggest that expected future inflation is not the major determinant of current inflation.