The (Un)Importance of Forward-Looking Behavior in Price Specifications
Revised article published in Journal of Money, Credit and Banking 29, no. 3 (August 1997): 338-50. Reproduced here with permission from the Ohio State University Press.
The seminal work of Phelps, Taylor, and Calvo developed forward-looking models of price determination that imparted inertia to the price level. These models incorporate expectations of future prices and excess demand by imposing constraints (typically lag-lead symmetry constraints) that force future variables to enter the specification. In this paper, I test the empirical significance of future prices in specifications like those of Taylor. I find that expectations of future prices are empirically unimportant in explaining price and inflation behavior. However, the dynamics of a model that includes a purely backward-looking inflation specification differ significantly-and not altogether pleasingly-from those with a forward-looking specification.