Abstract

Inflation volatility has significantly declined over the last 20 years in the U.S. To find out why, I follow a structural approach. I estimate a complete New Keynesian model which imposes cross-equation restrictions on the time series of inflation, the output gap, and the interest rate. I perform counterfactual analysis with two commonly used measures of inflation: Consumer price index (CPI) and gross domestic product deflator (GDPD). While the change in the propagation mechanism of the economy induced most of the CPI volatility drop, it played a smaller role in the reduction of GDPD volatility. Our maximum likelihood estimates imply that the most important factor behind the drop in inflation volatility was the more forward-looking price-setting behavior of the 1980s and 1990s.

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Additional Information

ISSN
1538-4616
Print ISSN
0022-2879
Pages
pp. 801-825
Launched on MUSE
2004-07-28
Open Access
No
Archive Status
Archived 2007
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