Model Specification and Inflation Forecast Uncertainty in the Case of Pakistan

Abstract

Making a better estimate of Inflation can enable us to make a better guesstimate about its economic repercussions. In modern monetary economics, the standard Phillips Curve model (PCM), the New Keynesian Phillips curve model (NPCM), and the incomplete competition model (ICM) are the alternative econometric models specified to forecast Inflation. The present study intends to identify the appropriate inflation model based on its forecasting performance with its different specifications for Pakistan's Economy.  PCM includes the output gap and unemployment rate, NPCM has forward-looking expectations and uses labor income share instead of the output gap, and ICM identifies the importance of incomplete information on labor and product markets and uses some error correction term (ECT) to forecast Inflation. The relevant ECT has overcome the omitted variable bias. ICM is better in visualization forecasting and has lower root mean square error and mean absolute percentage error than other inflation models. In conclusion, the wage-price dynamics model (ICM) offers the best prospect of a successful inflation forecast in the case of Pakistan.