Keywords: Inflation, M2 velocity, quantity equation
Abstract: This paper implements recursive techniques to estimate the equilibrium
level of M2 velocity and to forecast inflation using the P* model.
The recursive estimates of equilibrium velocity are obtained by applying
regression trees and least squares methods to a standard representation
of M2 demand, namely a model in which the velocity of M2 depends on the
opportunity cost of holding M2 instruments. Equilibrium velocity is
defined as the level of velocity that would be expected to obtain if
deposit rates were at their long-run average (equilibrium) value.
We simulate the alternative models to obtain real-time forecasts of
inflation and evaluate the performance of the forecasts obtained from
the alternative models. We find that while a $P^*$ model assuming a
constant equilibrium velocity does not provide accurate inflation
forecasts in the 1990s, a model based on our time-varying equilibrium
velocity estimates does quite well.
Full paper (316 KB PDF)
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