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Rational Expectations, Long-run Taylor Rule, and Forecasting Inflation

Economic Research Institute (82-2-759-5415) 2006.03.30 2650

Rational Expectations, Long-run Taylor Rule, and Forecasting Inflation 

Author :  Byeongseon Seo and Sokwon Kim(Texas A&M University )

The rational expectations model implies that nominal interest rates reflect expectations of inflation, and thus the term structure of interest rates provides information on the future change in inflation. However, the monetary authority manipulates the short-term interest rate in response to the change in the price level, and accordingly the prediction of inflation cannot be separated from the monetary policy. This paper explores the linkage between the monetary policy rules and the prediction of inflation. The prediction of inflation can be influenced by the monetary policy rules if the Fed reacts strongly to inflation. Using the long-run Taylor rule, an assessment of the prediction performance regarding future change in inflation is provided. The empirical results indicate that the long-run Taylor rule improves forecasting accuracy.