Short-Run Inflation Dynamics: Theories And China's Empirics

Macroeconomics has been moving towards a new synthesis over the last decade. A new generation of monetary business cycle models, generally referred to as New Keynesian models or New Neoclassical Synthesis models, has been developed. The new models integrate traditional Keynesian elements (imperfect competition and price rigidity) into a dynamic stochastic general equilibrium (DSGE) framework that was largely associated with the Real Business Cycle (RBC) paradigm. Analyses of money, inflation, business cycles and monetary policy can be conducted in these models, whose supply side is given by firms'optimal pricing decision, by which we can derive the New Keynesian Phillips curve (NKPC), the hybrid New Keynesian Phillips curve (HNKPC) or sticky information Phillips curve (SIPC). Those curves relate inflation to the real side of the economy, describing the short-run inflation dynamics and revealing one of the most fundamental structural macroeconomic relations. Understanding the dynamic nature is not only the key to the analyses of business cycle fluctuations but also premise of designs and evaluations of optimal monetary policy. The Phillips Curve or the underlying structural relation exerts the most fundamental constraint to the monetary policy analysis. It is in this sense that "among the central issues in macroeconomics is the nature of short-run inflation dynamics" (Gali and Gertler,1999).Domestic scholars have made remarkable progress in macroeconomics in recent years, deeper research, however, has to be made in analyzing the dynamic nature of short-run inflation. Meanwhile, monetary authorities also need to understand the dynamic evolution mechanism of inflation to establish proper monetary policy strategy. How does China's inflation relate to real variables such as output gap or marginal costs? Do forward-looking terms have significant effects on inflation dynamics? Is inflation persistent? If so, to what extent? Where does the persistence come? Is sticky information model appropriate for describing China's inflation dynamics? Does the cost channel have significant effect on short-run inflation dynamics? These questions are to be answered by related research and policy practice.The dissertation sums up three core topics aiming at the empirical nature of China's inflation dynamics:(a) the timing of the expectations, (b) the significance of structural persistence, and (c) the effect of the cost channel on short-run inflation dynamics. The three topics investigate the dynamic nature of China's short-run inflation from three aspects of expectation, lagged inflation and driving variables. The main content and structure of the dissertation are as follows.After introducing the research background, the first chapter, introduction, is concerned with the significance of short-run inflation dynamic on China's current academic research and policy making. The chapter also sums up the three core questions to be solved by the dissertation and illustrates the research content, research method, contributions and drawbacks as well as questions for further research.Chapter 2 is the literature review in the perspective of new synthesis. The chapter, with the new synthesis on macroeconomics as the starting point, reviews the literature on short-run inflation dynamic in the past ten years, including theoretical and empirical arguments and development on NKPC, HNKPC and SIPC. The chapter serves as the research basis for the following chapters.Dealing with the empirical features of inflation in China, Chapter 3 summarizes China's inflation experiences from four aspects of the fluctuations of inflation and its comovement with output, the persistence of inflation, the dynamic relation between inflation and output gap and between inflation and real marginal cost, and the dynamic effect of monetary policy shocks. The inflation experience summarized in this chapter establishes an empirical foundation for more formal modeling and plays an inspiring role in the choice of empirical strategy, estimating method and data in the following research.Chapter 4 discusses sticky prices, sticky information and the timing of inflation expectations. A simple pricing model is expanded with two cases of sticky prices and sticky information, deriving NKPC based on assumption of sticky prices and SIPC based on assumption of sticky information. The chapter then introduces quantity equation of money to establish a simple dynamic macroeconomic system and calibrates parameters to simulate the system, evaluating the effect of timing of inflation expectations on monetary policy transmission. Employing a moments matching method, the chapter estimate NKPC and SIPC separately with a minimal distance estimator.Chapter 5 conducts structural analysis on inflation persistence. A Markov regime switch model is exerted to verify whether inflation persistence changes in different regimes. The results confirm the high persistence. The chapter then conducts structural explanation of persistence, analyzing what parameter combination in the new Keynesian model is able to generate inflation autocorrelation function fitting empirical data. The chapter estimates HNKPC and the sacrifice ratio of disinflation also, and discusses the effect of intrinsic persistence on monetary policy. Chapter 6 deals with short-run inflation dynamics under the cost channel. The chapter derives NKPC with the cost channel under the assumption that the wage payments of the firm is subject to a CIA constraint. It then simulates a New Keynesian model with cost channel, studying whether the inflation's impulse response to interest rate shocks reflects the transmission mechanism of cost channel. Finally the chapter establishes a GMM estimator to verify whether China's data support NKPC with cost channel.Chapter 7 concludes the dissertation, and discusses the contributions and shortcomings of the dissertation.The main contributions of the dissertation are as follows. First, the dissertation describes the empirical features of China's inflation from variable perspectives and has some new findings. Second, it designs estimating strategy to conduct empirical comparison between NKPC and SIPC. Third, it compares model-predicted inflation autocorrelation function and estimated inflation autocorrelation function based on data, conducting structural analysis of inflation persistence. Fourth, it derives NKPC under cost channel and makes empirical test.The dissertation has the following findings. First, NKPC is dominant to SIPC for describing China's short-run inflation dynamic. Second, the forward-looking term plays an important role in short-run inflation dynamics. Third, combining inherited and intrinsic persistence together is a better way to explain the persistence of inflation. Fourth, introducing the cost channel helps explain inflation dynamics.