Pitfalls in Interpreting Tests of Backward-Looking Pricing in New Keynesian Models

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(ProQuest Information and Learning: Formulae omitted)

Recently macroeconomists have shown renewed interest in economic models that contain some form of nominal rigidity. These models are referred to generically as New Keynesian models. A particularly important feature of these models is sluggishness in price adjustment. However, there is substantial debate over whether this sluggishness arises from backward-looking adaptive behavior or from forward-looking behavior in the presence of costs in adjusting prices. It is also possible that the economy comprises two types of firms, one type that adjusts the price of its product based on some backward-looking policy and another type that sets its price based on current and anticipated market conditions. Because the nature of price setting is one of the key aspects of New Keynesian models, developing empirical tests that will inform theorists of the correct specification of pricing behavior is essential.

Also, from a policy perspective, understanding how firms set prices is of crucial importance because it determines what the effects of monetary policy will be. For example, as discussed in Ball (1994) and Roberts (1998), credible disinflations are relatively costless in New Keynesian models, but are quite costly from the perspective of traditional backward-looking Keynesian models.

In an attempt to shed empirical light on this question, economists have started investigating the behavior of inflation based on the null hypothesis that firms are indeed forward looking. The goal of this work is to test if forward-- looking price behavior is consistent with the actual behavior of prices and inflation. This strategy is attractive as a starting point because it is compatible with firms' optimizing behavior. If inhibitions to perfect price flexibility exist, such as adjustment costs or maintaining long-term customer relationships, then it is optimal for a firm to take account of how a chosen price will affect its future profit stream. That is, the firm's pricing decision will be forward looking in much the same way that current investment decisions are based on expectations of future economic conditions. Seminal work in this area has been carried out by Gali and Gertler (1999) and Sbordone (1998).

Many tests used to assess whether forward-looking pricing behavior adequately captures the behavior of inflation also investigate whether the addition of some backward-looking variables appreciably helps explain inflation. A finding that lags of inflation have marginal predictive content is interpreted to mean that a significant fraction of firms are backward looking. Further, this fraction can be estimated. The empirical debate has largely centered on what relevant variables, such as output gaps or marginal cost, should be included in the specification, how to properly measure the variables in question, and the estimation strategy itself. As of yet, there is no general consensus regarding how important forward-looking behavior is in a firm's pricing decisions.1

This article takes a different tack. To believe in forward-looking pricing is one thing; it is an entirely different matter to agree on what form that pricing behavior takes. Is it time or state dependent? If time dependent, which of the leading models best describes pricing behavior? Can it be represented by a Calvo-style or quadratic adjustment-cost model? Or is it more amenable to a staggered contracting model in the spirit of Taylor (1980)? As Kiley (1998) and Wolman (1999) have shown, these various models with forward-looking pricing have different implications for how shocks affect the economy and therefore are likely to give rise to different empirical interpretations of pricing behavior. As is also indicated in Guerrieri (2001), the models lead to very different estimable equations. I show that if data are actually generated by a forward-looking model of the Taylor pricing variety, and one estimates a pricing relationship based on Calvo-type behavior, then the conclusion that a significant fraction of firms are backward looking must follow. …

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