Estimated Open Economy New Keynesian Phillips Curves for the G7

contained in the labour share variable as this captures the distinction between
product and consumption wages which does not arise in the closed economy case.
In the usual closed economy estimates of the Phillips curve, the log-linearised
labour share, sbt, with χ = 1 (i.e. no international trade) is the appropriate
measure of marginal cost. In the open economy case care must be made to
maintain the distinction between consumption and product wages in defining
the labour share variable. This measure of marginal cost is augmented by a term
in the output gap yb_t which captures the rise in marginal costs when output is
above equilibrium given decreasing marginal returns in the variable factors of
production. It also includes a term in the price of labour relative to import
prices, Wct - pb_t^f which reflects the possibility of substituting between labour and
imported goods in production. There is also a straight terms of trade term,
pb_t^d - pb_t^f , which comes from the definition of GDP in the presence of intermediate
goods.

It should be noted that this specification nests the estimation of NKPCs in
other papers. For example, removing all the open economy elements (by ignoring
ffff

all international trade in final goods, χ = 1, and by assuming that ppdy = 0,
such that no imported intermediate goods are used in production), would return
us to the closed-economy specifications of among others, Sbordone (2002), Gali
et al (2000 and 2001) which include estimates for the US and Euro-area. By
only allowing trade in intermediate goods, but not final goods, this reduces to
the open economy specifications estimated for Spain by Gali and Lopez-Salido
(2001) and for the UK in Balakrishnan and Lopez-Salido (2001). In contrast,
in this paper we have developed a model which includes substitution not only
between labour and imported goods in production, but also between domestic
and foreign goods in consumption. We now turn to estimate our open economy
NKPC for the G7 economies.

3 Estimation and Empirical Results

In this Section we estimate the ‘deep parameters’ of the model derived in Section
2 for the G7 over the period 1960(1) to 1999(4)⁶ . These include the subjective
rate of time preference, β , the probability that a firm can reset their price in
period t, α, the proportion of firms following rule of thumb pricing behaviour
in time t, ω and the parameter measuring the elasticity of substitution between
labour and imported intermediate goods, ρ. We also examine the robustness of
these estimates and discuss them in the context of findings from other partial
and general equilibrium studies. This discussion allows us to draw a number of
conclusions of direct relevance to policy makers.

and is, therefore, applicable no matter how open the economy. This is the definition we shall
use in our empirical work below.

⁶ Further detail on sources and metho ds is reported in the Appendix II.

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