The role of inflation expectations in the EMU

Abstract

This article analyses the role of inflation expectations in the euro area. On the one hand, the question is how inflation expectations affect both inflation and output, and, on the other hand, how inflation expectations reflect developments in these variables. The analysis makes use of a simple VAR model of inflation, inflation expectations and output, which allows for scrutinizing the dynamic interrelationships between these variables. Empirical results strongly suggest that inflation expectations are the key ingredient of the inflationary process for the euro area and they have a significant negative effect on output. Inflation expectations are found to be relatively persistent – almost as persistent as output – albeit they do adapt to developments in both output and (actual) inflation, especially in the medium term.

Acknowledgement

Useful comments from Juha Tarkka and Jouko Vilmunen as well as financial support from the Yrjö Jahnsson Foundation are gratefully acknowledged.

Notes

¹ Experimenting with generalized impulse responses (Pesaran and Shin, 1998) points to the same direction.

² See Paloviita and Virén (2005) for more complete set of results including comparison of different inflation measures and inflation expectations (different time horizons/timings of expectations and use of the Consensus Forecast data). The article also reports vector error–correction model results, as well as results with differenced data and individual country data. They do not deviate substantially from those reported in this article.