Microfoundations of the New Keynesian Phillips Curve in an Open Emerging Economy

In an open economy setting, the slope in the New Keynesian Phillips Curve (NKPC) becomes sensitive to openness to trade, particularly so in emerging economies. The literature tends to overlook the underlying issues of this aspect, a shortcoming which we seek to address in this paper. We argue that a new Keynesian model framework with real rigidities can remedy to this limitation. To the literature's use of a constant domestic bias parameter, we substitute the concept of imperfect access to consumption goods. Our model incorporates real rigidities in the New Keynesian framework through domestic firm-level investment schedule, which determines aggregate openness to trade. We argue that capital-intensive goods are more integrated in global trade. The proposed model in this paper formulates a micro-founded Phillips curve augmented with an openness to trade component, which captures its ambiguous effects on inflation: strategic complementarity between domestic and foreign goods increases price stickiness, whereas competitive foreign products drive aggregate prices down. Finally, the paper describes welfare changes following different monetary policy regimes in an open economy setting. The welfare results implied by the usual tradeoff facing monetary authorities between exchange rate and inflation stability becomes sensitive to openness to trade.