Trend Inflation and Inflation Persistence in Australia: A New Keynesian Perspective

The empirical shortcomings of the purely forward-looking New Keynesian Phillips curve (NKPC) have generally been attributed to its inability to generate sufficient persistence in inflation. While the literature moved towards incorporating backward-looking terms into the NKPC, their somewhat ad-hoc rationales have been an ongoing source of criticism. This thesis attempts to ascertain the extent to which inflation dynamics in Australia can be explained by the NKPC without having to rely on such arbitrary backward-looking terms. Specifically, this analysis considers whether an adapted version of Cogely and Sbordone’s (2008) model of time-varying trend inflation is sufficient to explain the presence of the backward-looking term in Australia’s NKPC. The results show that even when time-varying trend inflation is taken into account, there remains a role for a backward-looking indexation. Moreover, when one considers the closed form estimates, lagged inflation and expected future inflation enter the NKPC with near equal weights. These results imply a considerably greater role for backward-looking behaviour when compared to typical GMM estimates of the Australian NKPC, which suggest that inflation is predominantly forward-looking. ∗I would firstly like to thank my supervisor, Denny Lie, for his expert suggestions in forming the concept for this analysis and also for his guidance and unwavering assistance during the writing of this thesis. I am also grateful for his diligence in responding to my countless emails and queries. I also thank Tim Robinson at the Reserve Bank of Australia for generously providing the raw data used in this thesis. The skills I have acquired in macroeconomic analysis during the course of this year have also been greatly beneficial in writing this thesis. As such, I am indebted to my lecturers Dr. Aarti Singh, Dr. Yunjong Eo and Professor Adrian Pagan. Finally, I also thank Diane Hutchinson and Russell Ross for their advice throughout the year. This thesis is submitted in partial fulfilment of the requirements for the Bachelor of Economics (Honours). October, 2011. Email address: [email protected] Statement of Originality I hereby declare that this submission is my own work and to the best of my knowledge it contains no materials previously published or written by another person, nor material which to a substantial extent has been accepted for the award of any other degree or diploma at University of Sydney or at any other educational institution, except where due acknowledgement is made in the thesis. Any contribution made to the research by others, with whom I have worked at University of Sydney or elsewhere, is explicitly acknowledged in the thesis. I also declare that the intellectual content of this thesis is the product of my own work, except to the extent that assistance from others in the project’s design and conception or in style, presentation and linguistic expression is acknowledged. Signed: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Date: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .