ABSTRACT
We estimate simultaneous-equation systems for the United States (March 1960 to March 2022) and New Zealand (Mar 1992 to Jun 2022) and test theoretical cross-equation restrictions. The Phillips curve has serious specification and estimation issues. The explanatory variables, expected inflation and the output gap, are unobservable, hence measurement errors. Policymakers and economic agents in these two countries and maybe in other inflation-targeting countries must have strongly believed that inflation expectations have been anchored, thus they assumed that expected inflation tomorrow is proportional to inflation today, e.g., . This assumption when with explains their inability to foresee the most recent rise in inflation. The assumption results in systematic under-prediction of inflation. A New Keynesian active monetary policy affects inflation via the output gap with long and variable lags; hence, the central banks should act earlier and on the basis of anticipated inflation. The inability of the central bank to forecast inflation means they would be acting late and strong, based on observed rather anticipated rising inflation, which is a serious policy error. Policy errors are notoriously persistent and very costly to undo.
