Behavioral Heterogeneity in U.S. Inflation Dynamics

In this paper we develop and estimate a behavioral model of inflation dynamics\r\nwith heterogeneous firms. In our stylized framework there are two groups of price\r\nsetters, fundamentalists and random walk believers. Fundamentalists are forward-\r\nlooking in the sense that they believe in a present-value relationship between inflation\r\nand real marginal costs, while random walk believers are backward-looking, using the\r\nsimplest rule of thumb, naive expectations, to forecast inflation. Agents are allowed\r\nto switch between these different forecasting strategies conditional on their recent\r\nrelative forecasting performance. We estimate the switching model using aggregate\r\nand survey data. Our results support behavioral heterogeneity and the significance of\r\nevolutionary learning mechanism. We show that there is substantial time variation in\r\nthe weights of forward-looking and backward-looking behavior. Although on average\r\nthe majority of firms use the simple backward-looking rule, the market has phases in\r\nwhich it is dominated by either the fundamentalists or the random walk believers.