A Historical Evaluation of Inflation Dynamics and the Role of Inflation Expectations

Abstract: We employ a VAR-model to study the dynamics of inflation and the role of inflation expectations and other macro economic variables to the inflation process with annual data over the period 1880-2005 in Denmark, France, Germany, Italy, Sweden, The UK and The US. We divide the period into four sub-periods following the Lucas critique (1976). The periods under examination are: 1880-1913, 1914-1939, 1950-1971 and 1972-2005 and the variables studied besides inflation expectations are long run excess money growth, short term interest rate and output-gap. This helps us interpreting the changing role of inflation expectations over the period. Because of the limitations of the VAR-model we also complement the method with correlation schemes and OLS-regressions with ad-hoc selection of lags based on the correlation schemes. We find weak evidence on rational expectations up until 1972 where the expectations to a larger extent can help explain the inflation process. The results suggest that inflation expectations are more adaptive than rational. Up until 1972 there are no signs that inflation expectations would be a leading variable to inflation.