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Calvo pricing and imperfect common knowledge: a forward looking model of rational inflation inertia

  • Nimark, Kristoffer P.

In this paper we derive a Phillips curve with a role for higher order expectations of marginal cost and future inflation. We introduce a small idiosyncratic component in firms’ marginal costs and let the economywide average marginal cost be unobservable to the individual firm. The model can then replicate the backward looking component found in estimates of the ’Hybrid’ New Keynesian Phillips Curve, even though the pricing decision of the firm is entirely forward looking. The Phillips curve derived here nests the standard New Keynesian Phillips Curve as a special case. We take a structural approach to imperfect common knowledge that allow us to infer whether the assumed information imperfections necessary to replicate the data are quantitatively realistic or not. We also provide an algorithm for solving a class of models involving dynamic higher order expectations of endogenous variables. JEL Classification: E00, E31, E32

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Paper provided by European Central Bank in its series Working Paper Series with number 0474.

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Date of creation: Apr 2005
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Handle: RePEc:ecb:ecbwps:20050474
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  1. Hyun Song Shin & Jeffery D. Amato, 2003. "Public and private information in monetary policy models," BIS Working Papers 138, Bank for International Settlements.
  2. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
  3. Adam, Klaus, 2003. "Optimal monetary policy with imperfect common knowledge," Working Paper Series 0223, European Central Bank.
  4. Mark Bils & Peter J. Klenow, 2002. "Some Evidence on the Importance of Sticky Prices," NBER Working Papers 9069, National Bureau of Economic Research, Inc.
  5. Carlton, Dennis W, 1986. "The Rigidity of Prices," American Economic Review, American Economic Association, vol. 76(4), pages 637-58, September.
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