This paper studies the usefulness of the P-star model in the analysis of the behaviour of prices in Australia and New Zealand. The P-star model is based on the quantity theory of money and the belief that the price level tends to move towards the equilibrium price level. The main contribution of this model is the use of the price gap - the difference between current price and the equilibrium price (P-star) - to forecast inflation. Hence, if the equilibrium price is greater than the current price, there is a tendency for the price level to rise. The equilibrium price in this approach is determined by potential output, the equilibrium velocity of money and the amount of money in the economy. In this study, potential output and equilibrium velocity, which are necessary variables in the construction of the equilibrium price level (P-star), are derived using the Hodrick and Prescott filter. The information contained in the price gap about Australian and New Zealand inflation is examined using an error correction model. In contrast to findings for the USA, the evidence does not strongly support the P-star model for Australian prices. However, results support the P-star model for the New Zealand case. Furthermore, according to the proponents of the P- star model the lagged value of the price gap must be significant in the model of inflation. But results of this study suggest that the contemporary value of the price gap is significant and it is difficult to provide a theoretical interpretation for this finding.
