Behavioral Heterogeneity in U.S. Inflation Dynamics

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