allow them to trend upwards over time, and found the estimates reported in the
paper to be robust to this change11 .
4 Conclusions
In this paper we developed a model of firms’ pricing behaviour in the context of
an open economy model, where imperfectly competitive firms sell their products
both at home and abroad, and produce their good by using a combination
of local labour, capital and imported intermediate goods. This allows us to
introduce various terms of trade effects influencing the firm’s pricing decision,
in addition to labour costs which dominate most closed-economy specifications
of the NKPC. We assumed that firms were sub ject to the constraints on the
timing of their price changes in the form of Calvo(1983) contracts, such that
they can only change price after a random interval of time has passed. We
also allow firms to operate two types of pricing policy. The first is where firms
attempt to maximise the discounted value of profits, while under the second
a firm may choose to follow a simple rule of thumb which updates prices in
line with observed price changes and inflation. This setup gave rise to a hybrid
open economy NKPC which nests all of the specifications adopted in empirical
work on individual countries. We then estimated this specification for the G7
economies.
Our empirical results suggest that the US, Canada and UK economies suffer
from less price inertia than European members of the G7 and Japan. A notable
exception to this rule is Italy, although here the proportion of backward-looking
price setters is the highest in the G7, possibly suggesting that the relatively
frequent price adjustment in Italy is a result of indexation mechanisms rather
than more conventional notions of price flexibility. Another interesting result is
that firms in countries where the frequency of price change is greatest are more
likely to employ backward-looking rules of thumb. This probably reflects the
fact that the costs of failing to set a price optimally are lower when that price
is unlikely to remain in place for long.
Another key finding is that these results hold true whether we adopt a closed
economy or an open economy specification of the Phillips curve, i.e. our esti-
mates of model parameters are not significantly different under these alternative
specifications. Additionally, we found that we could not reject the restriction
that the elasticity of substitution between imported goods and labour in pro-
duction was unity (i.e. the Cobb-Douglas case) for all the G7 economies, except
the US. Again, imposing this parameter restriction (even for the US) did not
materially affect estimates of the degree of nominal inertia in the G7. This sug-
gests that our parameter estimates can be used in a wide-variety of theoretical
and simulation work, both in closed and open economy contexts, and with a
variety of production functions. An obvious extension of our research would be
11To preserve space these results are not reported here but will be made available on request
from the authors.
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