Japan at 9 months, France at just over 9 months and Germany being an outlier
with the longest time between price adjustment across all firms in the economy
of close to 2 years. The ranking of economies according to the estimated degree
of inertia is not implausible with the US, UK and Canada in general possessing
a greater degree of price flexibility than the European economies within the
G7 or Japan. The apparent degree of price flexibility in Italy is perhaps more
surprising, especially when compared with other EMU members. However, in
Italy the proportion of firms adopting backward-looking rules of thumb is the
highest at 39% and so these estimates possibly reflect the existence of indexation
mechanisms rather than genuine price flexibility. In relation to other studies the
estimates for the US are in line with other studies in the literature such as, for
example, Gali et al (op. cit.), and Leith and Malley (op. cit.). The figures for
Canada are also consistent with those reported in Gagnon and Kahn (2001).
The estimates of the degree of backward-looking behaviour also vary across
the G7 economies, ranging from 6% of firms in the UK to 39% in Italy. It
also appears, with the exception of the UK, that the less frequently a country
changes prices then the more likely firms are to use backward-looking rules of
thumb. This probably reflects the information gathering costs implicit in setting
a profit-maximising price and the costs of failing to maximise profits. If firms
only change prices infrequently then they will use all available information to set
that price carefully when the opportunity arises, while with less nominal inertia
there are less costs involved in setting a rule of thumb price. The estimates of β
are in line with other studies, although as a measure of consumers’ rate of time
preference they are slightly low, probably reflecting the extent to which firms
discount the future to take account of elements of risk not formally included in
our model.
When we introduce the open economy elements in model M2 then this does
not significantly alter the estimates of the consumers’ discount factor, β the
probability of price adjustment, α, and the proportion of backward-looking price
setters, ω (see column 1 of Tables 2 and 3 for the t-stats associated with test-
ing the null that the α,s and ω,s estimated in the open economy specification
are significantly different from those estimated in model M2). The countries
in which introducing open economy aspects makes the greatest difference are
Canada and France and to a lesser extent Italy and the UK. A relatively closed
economy, such as the US, experiences no change in the estimated degree of
price inertia at all through adding open economy considerations. These differ-
ences translate into an increase in the estimate of the average time for all firms
to adjust their prices in Canada from 9 to 11 months. However, it must be
stressed that this difference is not statistically significant, and the changes in
other countries are even smaller. The estimated proportion of rule of thumb
price setters is also largely invariant to introducing open economy effects - the
estimated proportion of backward-looking price setters, changes by less than
3%, with most countries experiencing far smaller changes. Again, these changes
are insignificant in statistical terms.
In M3 we consider the impact of imposing a Cobb-Douglas form of pro-
duction function by setting the elasticity of substitution between labour and
13