The Forecast Performance of Alternative Models of Inflation

What determines inflation? Several theoretical models of the inflation process have been advanced in the literature, and these models typically yield different predictions about the role of certain variables in determining prices. To illustrate, consider, for example, the expectations-augmented Phillips curve model. This model generally assumes prices are set as a markup over labor costs, the latter being determined by expected inflation and the degree of demand pressure. It is assumed further that expected inflation is a function of past price history, and demand pressure can be measured by the excess of real growth over potential (termed the output gap). Thus, in the reduced-form price equation associated with the Phillips curve model, past prices and the output gap (or another demand pressure variable) play a key role in determining the price level. This model thus implies that by monitoring the behavior of these two variables one could assess the outlook for inflation. Another example is provided by the price equation associated with the traditional monetarist model. In this equation, lagged money growth is the predominant force in price determination. Thus, depending upon the nature of the price structure chosen different determinants of inflation have been suggested in the literature