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"Testing Price Equations
European Economic Review, November 2008, 1424-1437,
Testing Price Equations.
How inflation and unemployment are related in both the short run and long
run is perhaps the key question in macroeconomics. This paper tests various
price equations using quarterly U.S. data from 1952 to the present.
Issues treated are the following. 1) Estimating price and wage equations
in which wages affect prices and vice versa versus estimating
``reduced form'' price equations with no wage explanatory variables.
2) Estimating price equations in (log) level terms, first difference
(i.e., inflation) terms, and second difference (i.e., change in inflation)
terms. 3) The treatment of expectations. 4) The choice and functional form
of the demand variable. 5) The choice of the cost-shock variable.
The results suggest that the
best specification is a price equation in level terms imbedded in a
price-wage model, where the wage equation is also in level terms. The
best cost-shock variable is the import price deflator, and the best
demand variable is the unemployment rate. There is some evidence of
a nonlinear effect of the unemployment rate on the price level at low
values of the unemployment rate.
Many of the results in this paper are contrary to common
views in the literature, but the empirical support for them is strong.