imported intermediate goods, ρ,to1. This restriction is a valid restriction on
the freely estimated values of ρ for all countries except the US. Again imposing
the Cobb-Douglas form in our open economy model has no significant effect
on the estimated parameters of the model. Finally, in M4 we impose a lower
elasticity of substitution between imported intermediate goods and labour in
production of 1/3. This is consistent with the value imposed in McCallum
(2001) and severely limits the extent to which labour can be substituted for
imported goods in production in response to price changes (and therefore limits
the extent to which firms can insulate marginal costs from changes in the price
of imports used in production). Imposing this elasticity, significantly reduces
the estimated time period of price adjustment in Germany, and the proportion
of backward-looking price setting in Italy. It has a negligible and insignificant
impact on other parameters estimates for other countries. This change brings
the estimate of inertia in Germany closer to the estimates for other countries in
our sample and increases the estimated level of backward-looking behaviour to
50% in the case of Italy. However, we also see from Table 4, that imposing this
value of ρ is not a valid parameter restriction on the freely estimated ρ in the
case of Italy and the US, but is for the other G7 economies. In other countries
imposing this elasticity of substitution does not significantly affect the estimates
of the degree of nominal inertia. Our results therefore appear to suggest that
introducing open economy considerations to the NKPC does not significantly
affect the estimated degrees of nominal inertia and backward-looking behaviour
for the G7 economies. Of course, this does not imply that analysis of the im-
pact of monetary and fiscal policy need only consider closed economy models.
In a general equilibrium context, open economy factors could have a significant
impact through the endogenous determination of the labour share which is very
influential in price-setting behaviour in the NKPC. This observation notwith-
standing, we can safely conclude that our estimates can be employed in a wide
variety of closed and open economy models which are nested within our general
specification.
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