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Simple Pricing Rules, the Phillips Curve and the Microfoundations of Inflation Persistence

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  • Richard Mash

    (Oxford University)

Abstract

Models in which pricing decisions depend on indexing or rule of thumb behaviour have become prominent in the monetary policy literature and tend to match macroeconomic data well given their prediction of inflation persistence. The extent to which firms index their prices to past inflation has been assumed constant. We explore the consequences of endogenising the degree of indexing such that firms move closer to constrained optimal prices and find that the degree of indexing depends sensitively on firms’ perceptions of the degree of persistence in the economy. This has striking implications. Firstly models in which the degree of indexing is fixed are vulnerable to the Lucas critique since that parameter will change in different regimes. Secondly we study the interactions between perceived persistence, which governs indexing and thus the quantitative significance of lagged inflation in the Phillips curve, and actual persistence which depends on the latter. We find that if firms adjust their indexing behaviour to actual persistence, lagged inflation disappears from the Phillips curve and the models no longer predict persistence

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Bibliographic Info

Paper provided by Money Macro and Finance Research Group in its series Money Macro and Finance (MMF) Research Group Conference 2006 with number 141.

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Date of creation: 02 Feb 2007
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Handle: RePEc:mmf:mmfc06:141

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Web page: http://www.essex.ac.uk/afm/mmf/index.html

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Keywords: Monetary policy; Phillips curve; Inflation Persistence; Microfoundations; Indexing;

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Cited by:
  1. Sujit Kapadia, 2005. "Inflation-Target Expectations and Optimal Monetary Policy," Money Macro and Finance (MMF) Research Group Conference 2005 81, Money Macro and Finance Research Group.
  2. Sujit Kapadia, 2005. "Optimal Monetary Policy under Hysteresis," Economics Series Working Papers 250, University of Oxford, Department of Economics.
  3. Bruchez, Pierre-Alain, 2007. "A Hybrid Sticky-Price and Sticky-Information Model," MPRA Paper 3540, University Library of Munich, Germany.

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