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Inflation Dynamics: A Cross-Country Investigation FEDERAL RESERVE BANK OF ST.

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63166 RESEARCH DIVISION Working Paper Series Pengfei Wang and Yi Wen Working Paper 2005-076D https://doi.org/10.20955/wp.2005.076 November

2005 The views expressed are those of the individual authors and do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis, the Federal Reserve System, or the Board of Governors. Federal Reserve Bank of St. Louis Working Papers are preliminary materials circulated to stimulate discussion and critical comment. References in publications to Federal Reserve Bank of St. Louis Working Papers (other than an acknowledgment that the writer has had access to unpublished material) should be cleared with the author or authors. In?ation Dynamics: A Cross-Country Investigation Pengfei Wang Department of Economics Cornell University Yi Wen Research Department Federal Reserve Bank of St. Louis July 3,

2006 Abstract We document that persistent and lagged in?ation (with respect to output) is a world- wide phenomenon in that these short-run in?ation dynamics are highly synchronized across countries. In particular, the average cross-country correlation of in?ation is signi…cantly and systematically stronger than that of output, while the cross-country correlation of money growth is essentially zero. We investigate whether standard monetary models driven by monetary shocks are consistent with the empirical facts. We …nd that neither the new Keynesian sticky-price model nor the sticky-information model can fully explain the data. An independent contribution of the paper is to provide a simple solution technique for solving general equilibrium models with sticky information. Keywords: Sticky Information, Sticky Prices, In?ation Dynamics, In?ation Comovement, Money. JEL Codes: E31, E32, E40. We thank Barseghyan Levon, Bill Gavin, Ed Green, Ed Nelson, Ricardo Reis, Karl Shell, Dan Thornton, Tao Zhu, seminar participants at Cornell-Penn State Macroeconomic Conference (Fall 2005) and the Federal Reserve Bank of St. Louis, an anonymous referee and the Editor, Bob King, for helpful comments, and John McAdams for excellent research assistance. The views expressed in the paper and any errors that may remain are the authors'

alone. Correspondence: Yi Wen, Research Department, Federal Reserve Bank of St. Louis, St. Louis, MO, 63144. Phone: 314-444-8559. Fax: 314-444-8731. Email: [email protected].

1 1 Introduction The nature of short-run in?ation dynamics is one of the most eminent issues in macroeconomics. It can be traced back in the literature to at least as early as Phillips (1958). Although sophisticated, the modern incarnation of the sticky-price theory, based on the early work of Taylor (1980) and Calvo (1983), is incapable of explaining in?ation dynamics in two important aspects (as noted by Fuhrer and Moore, 1995): First, it cannot explain the persistence in the in?ation rate. Second, it cannot explain why in?ation systematically lags output. The lack of in?ation persistence in the models implies that monetary policy can drive a positive rate of in?ation to zero with virtually no loss of output (see, e.g., Fuhrer and Moore, 1995). It also implies that announced disin?ations can cause booms rather than recessions, which contradicts the historical experience of the U.S. economy (Ball, 1994). Further, the forward-looking property of the in?ation dynamics embodied in the standard sticky-price model implies that a policy of permanently falling in?ation can keep output permanently high. This implication is criticized by McCallum (1998) on the grounds that it violates a strict form of the natural rate hypothesis, according to which there is no in?ation policy that will keep output permanently high. In response to this challenge, Mankiw and Reis (2002) develop a sticky-information model in which information di¤uses slowly throughout the population. This slow di¤usion could arise because of costs of acquiring information or costs of reoptimization. As a consequence, …rms'