Inflation Dynamics in a Small Open Economy

We evaluate the empirical performance of forward-looking models for inflation dynamics in a small open economy. Using likelihood-based testing procedures, we find that the exact formulation is at odds with Norwegian data. Moreover, some of the parameters in the model are not well identified. We also find that the inexact formulation is not rejected statistically using a test based on a minimum distance method. However, confidence regions also reveal an identification problem with this model. Instead, we find a well-specified backward-looking model with imperfect competition underlying the price setting, which is a model that outperforms an alternative forward-looking model in-sample. The backward-looking model also forecasts somewhat better than the alternative forward-looking model, during and after the recent financial crisis.