Models in which firms use a rule of thumb or partial indexing in price setting are prominent in the recent monetary policy literature. The extent to which these firms adjust their prices to lagged inflation has been taken as fixed. We consider the implications of firms choosing the optimal degree of indexation so these simple pricing rules deliver prices as close as possible to those which would be chosen optimally. We find that the degree of indexation depends on the extent of persistence in the economy such that models with constant indexation are vulnerable to the Lucas critique. We also study the interactions between firms’ price setting and the macroeconomic environment finding that, for the models which appear most plausible on microeconomic grounds, the Nash equilibrium between firms and the policy maker is characterised by zero indexation and zero macroeconomic persistence.
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Paper provided by Kiel Institute for the World Economy in its series Economics Discussion Papers with number
2007-36.
Find related papers by JEL classification: E22 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Capital; Investment; Capacity E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
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