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Reaching Inflation Stability
- Journal of Money, Credit, and Banking
- The Ohio State University Press
- Volume 36, Number 4, August 2004
- pp. 801-825
- 10.1353/mcb.2004.0066
- Article
- Additional Information
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.