Bounded rationality in rules of price adjustment and the Phillips Curve

This paper presents a model of endogenous bias in rules of price adjustment that allows one to analyse the behaviour of inflation and output continuously throughout the entire spectrum of rationality, from one end to the other. Specifically, it proposes an alternative microfoundation for both the New Keynesian sticky-price and the sticky-information Phillips Curve by considering a possibility where price setters are constrained by the length of the time horizon over which they can form rational expectations, and they use the growth of past prices at the rate of the central bank’s inflation target as a heuristic alternative in place of their own expectations beyond this horizon. Three interesting results emerge. Firstly, how price setters form inflation expectations and whether these expectations are accurate or heterogeneous do not matter when they are able to gather information or change prices more frequently. Secondly, should policymakers expect private agents to similarly adopt the inflation target as a nominal anchor for their own expectations, then even the choice of this numerical target could prove to be pivotal to output stabilization. Thirdly, larger degrees of bounded rationality increase the persistence of inflation, and, under sticky-information, raise the possibility of discontinuous jumps and oscillatory dynamics of inflation and real output. ⇤