Muth’s Hypothesis Under Knightian Uncertainty : A Novel Account of Inflation Forecasts

We open a New Keynesian Phillips curve model to nonrecurring structural shifts in its parameters and propose a novel implementation of Muth’s hypothesis to represent market participants’ inflation expectations under Knightian uncertainty arising from such shifts. We refer to our approach as the Knight-Muth hypothesis (KMH). We find empirical support for KMH’s core premise that processes driving inflation time-series and inflation forecasts undergo nonrecurring structural shifts. In contrast to the rational expectations hypothesis and behavioral specifications, KMH reconciles model consistency with an autonomous role for participants’ expectations in driving aggregate outcomes and the influence of psychological factors on those expectations