PRICE PREDICTION ERRORS AND REAL ACTIVITY: A REASSESSMENT

Rational expectations, natural‐rate macro‐models in which aggregate demand disturbances affect the real sector through price prediction errors, while powerful and tractable analytical tools, are often perceived to be of questionable empirical relevance. This paper reexamines the empirical role of price prediction errors in determining the level of real aggregate activity. The approach is distinguished by accounting for aggregate supply‐side disturbances and by more careful treatment of natural rates. Contrary to some previous studies, we find considerable empirical support for the hypothesis that demand‐driven price level surprises are positively and significantly correlated with aggregate real economic activity.