Simple Pricing Rules, the Phillips Curve and the Microfoundations of Inflation Persistence
We analyze the microfoundations of the Phillips curve, a key relationship in general macroeconomics and models of monetary policy in particular. The form in current widespread use includes both forward looking expected inflation and lagged inflation. The presence of lagged inflation is necessary to generate predicted inflation persistence to match actual persistence in real world data but it has proved very difficult to microfound. Recent contributions from Christiano, Eichenbaum and Evans (JPE, 2005) and Gali and Gertler (JME, 1999) have attempted to provide such microfoundations through the assumption of indexing or rule of thumb behaviour. We question the nature of the indexing rules or rules of thumb assumed and re-derive these models for the case where firms choose constrained optimal simple pricing rules. We find that the models no longer convincingly predict inflation persistence
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 firmsâ€™ 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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