A Financial New Keynesian Model

Author(s): Thomas M. Mertens and Tony Zhang

This paper solves a standard New Keynesian model in terms of risk-neutral expectations and estimates it using a cross-section of longer-dated financial assets at a single point in time. Inflation risk premia appear in the theory and cause inflation to deviate from its target on average. We re-estimate the model based on each day’s closing prices to capture high-frequency changes in the expected path of the economy. Our estimates show that financial markets reacted to the post-COVID surge in inflation with higher short-run inflation expectations, an increase in the inflation risk premium, and an increase in the long-run neutral real rate, 𝑟∗, while long-term inflation expectations remained well anchored. Our model produces long term inflation forecasts that outperform several standard alternative measures.

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Article Citation

Mertens, Thomas M, and Tony Zhang. 2023. "A Financial New Keynesian Model," Federal Reserve Bank of San Francisco Working Paper 2023-35. Available at https://doi.org/10.24148/wp2023-35