Inflation Dynamics in a Small Open Economy

Abstract

We evaluate the empirical performance of forward-looking models for inflation dynamicsin a small open economy. Using likelihood-based testing procedures, we find that the exactformulation is at odds with Norwegian data. Moreover, some of the parameters in themodel are not well identified. We also find that the inexact formulation is not rejectedstatistically using a test based on a minimum distance method. However, confidence regionsalso reveal an identification problem with this model. Instead, we find a well-specifiedbackward-looking model with imperfect competition underlying the price setting, which isa model that outperforms an alternative forward-looking model in-sample. The backward-looking model also forecasts somewhat better than the alternative forward-looking model,during and after the recent financial crisis. Keywords: Backward-looking; cointegrated vector autoregressive models; equilibrium correc-tion models; forward-looking; likelihood-based methods; minimum distance method