example Gali and Gertler (1999), Gali et al (2001), Sbordone (2002) and Leith
and Malley (2001)) suggests that, as a measure of inflationary pressures, the
output gap is a poor proxy for marginal costs. Accordingly, when a theoretically
coherent NKPC is estimated for the US and Euro-area, using log-linearised
labour share data as a measure of marginal costs, the NKPC appears to be a
reasonable model of inflation.
In this paper we build on the insight of this approach, but extend the analy-
sis to take account of open economy terms of trade effects in the determination
of output price inflation. More specifically, we construct a model of firms’ price
setting behaviour which allows firms to sell their products in both home and for-
eign markets and to substitute imported intermediate goods for domestic labour
in production. These extensions imply that we capture two channels through
which terms of trade effects may influence the firm’s price setting decisions via
their impact on marginal costs. Firstly, we allow for changes in demand for do-
mestic products relative to those produced abroad and secondly for changes in
the prices of imported intermediate goods relative to other inputs in the produc-
tion process. In our setup firms will set their prices subject to the constraints
implied by Calvo contracts. When firms are able to adjust prices, some will set
the new price to maximise the discounted value of future profits, while others
will follow a simple backward-looking rule of thumb which, although not opti-
mal in the short-run, will achieve the profit-maximising price in the long-run.
The possible existence of rule of thumb price setters may reflect information
processing costs along the lines of Sims (1998) and allows us to measure the ex-
tent of backward-looking behaviour in price setting. Our formulation gives rise
to a specification of the NKPC which nests existing closed and open economy
models (see for example, Sbordone (2002), Gali et al (2000 and 2001) and Gali
and Salido -Lopez (2001) and Balakrishan and Salido-Lopez (2001)).
When we econometrically estimate our specification of price setting behav-
iour for the G7 economies we find plausible estimates of the degree of inertia
in each economy. Moreover these results suggest that the UK, US and Canada
enjoy less inertia than other European members of the G7 and Japan. Our
econometric work also suggests that the majority of firms set prices optimally,
in a forward-looking manner, rather than following backward-looking rules of
thumb. It also appears to be the case that in countries where firms change prices
relatively frequently, the proportion of backward-looking price setters increases.
This probably reflects the fact that the costs of failing to optimise every reset
price are lower when that price is unlikely to remain in force for long. Finally,
our results imply that there are significant asymmetries in the degree of price-
stickiness among EMU member states as well as asymmetries in the degree of
backward-looking behaviour in price setting, which may be a cause for concern
for policy makers in the ECB.
The rest of the paper is organised as follows. In Section 2 we derive our
open economy NKPC. In Section 3 we estimate the model for the G7 economies.
Section 4 contains our conclusions.