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Calvo pricing and imperfect common knowledge: a forward looking model of rational inflation inertia

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  • Nimark, Kristoffer P.

Abstract

In this paper we derive a Phillips curve with a role for higher order expectations of marginal cost and future inflation. We introduce a small idiosyncratic component in firms' marginal costs and let the economywide average marginal cost be unobservable to the individual firm. The model can then replicate the backward looking component found in estimates of the 'Hybrid' New Keynesian Phillips Curve, even though the pricing decision of the firm is entirely forward looking. The Phillips curve derived here nests the standard New Keynesian Phillips Curve as a special case. We take a structural approach to imperfect common knowledge that allow us to infer whether the assumed information imperfections necessary to replicate the data are quantitatively realistic or not. We also provide an algorithm for solving a class of models involving dynamic higher order expectations of endogenous variables. JEL Classification: E00, E31, E32

Suggested Citation

  • Nimark, Kristoffer P., 2005. "Calvo pricing and imperfect common knowledge: a forward looking model of rational inflation inertia," Working Paper Series 474, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:2005474
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    File URL: https://www.ecb.europa.eu//pub/pdf/scpwps/ecbwp474.pdf
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    References listed on IDEAS

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    1. Mark Bils & Peter J. Klenow, 2004. "Some Evidence on the Importance of Sticky Prices," Journal of Political Economy, University of Chicago Press, vol. 112(5), pages 947-985, October.
    2. Adam, Klaus, 2007. "Optimal monetary policy with imperfect common knowledge," Journal of Monetary Economics, Elsevier, vol. 54(2), pages 267-301, March.
    3. Hyun Song Shin & Jeffery D. Amato, 2003. "Public and private information in monetary policy models," BIS Working Papers 138, Bank for International Settlements.
    4. Carlton, Dennis W, 1986. "The Rigidity of Prices," American Economic Review, American Economic Association, vol. 76(4), pages 637-658, September.
    5. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-1311, July.
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    Cited by:

    1. Adam, Klaus, 2007. "Optimal monetary policy with imperfect common knowledge," Journal of Monetary Economics, Elsevier, vol. 54(2), pages 267-301, March.
    2. Jan Babecký & Fabrizio Coricelli & Roman Horváth, 2009. "Assessing Inflation Persistence: Micro Evidence on an Inflation Targeting Economy," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 59(2), pages 102-127, June.
    3. Ichiro Fukunaga, 2007. "Imperfect Common Knowledge, Staggered Price Setting, and the Effects of Monetary Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(7), pages 1711-1739, October.
    4. Guido Lorenzoni, 2009. "A Theory of Demand Shocks," American Economic Review, American Economic Association, vol. 99(5), pages 2050-2084, December.
    5. Ian Babetskii & Fabrizio Coricelli & Roman Horváth, 2007. "Measuring and Explaining Inflation Persistence: Disaggregate Evidence on the Czech Republic," Working Papers IES 2007/22, Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies, revised Aug 2007.
    6. Stephen Morris & Hyun Song Shin, 2006. "Inertia of Forward-Looking Expectations," American Economic Review, American Economic Association, vol. 96(2), pages 152-157, May.
    7. Guido Lorenzoni, 2007. "News Shocks and Optimal Monetary Policy," NBER Working Papers 12898, National Bureau of Economic Research, Inc.

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    More about this item

    Keywords

    Calvo pricing; Higher order expectations; Imperfect Common Knowledge; New-Keynesian Phillips Curve;
    All these keywords.

    JEL classification:

    • E00 - Macroeconomics and Monetary Economics - - General - - - General
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles

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