No. 1033 - Does trend inflation make a difference?

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by Michele Loberto and Chiara Perricone September 2015

Although the average inflation rate of developed countries in the postwar period has been greater than zero, much of the extensive literature on monetary policy has employed models that assume zero steady-state inflation.

In comparing four estimated medium-scale NK DSGE models with real and nominal frictions, we seek to shed light on the quantitative implications of omitting trend inflation, that is, positive steady-state inflation. We compare certain population characteristics and the IRFs for the four models by applying two loss functions based on a point distance criterion and on a distribution distance criterion, respectively.

Finally, we compare the RMSE forecasts. We repeat the analysis for three sub-periods: the Great Inflation, the Great Moderation and the union of the two periods. We do not find clear evidence for always preferring a model that uses trend inflation.

Published in 2017 in: Economic Modelling, v. 61, pp. 351–375

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