Testing an Alternative Price-Setting Behavior in New Keynesian Phillips Curve: Extrapolative Price-Setting Mechanism

Hybrid New Keynesian Phillips curve (NKPC) has been widely used in monetary policy literature (e.g. Gali and Gertler, 1999) as it contains both forward-looking and backward-looking components and therefore fits the data well. A typical backward-looking part of price setting behavior assumes that firms use the previous period’s price. In this paper, we propose a generalized version of the hybrid NKPC by incorporating extrapolative (adaptive) price-setting mechanism in backward-looking part of the price setting behavior. We assume that when firms set the price at period t, they use information on price in period t-1 plus a portion of the change in prices between t-1 to t-2, which permits the trend in past price changes (partial error correction). Under this generalized setting, we derive reduced and structural NKPC explicitly. It turns out that the newly derived NKPC is a nesting model of the original hybrid NKPC in Gali and Gertler (1999). The empirical results show that the extrapolative component is strongly significant in explaining the inflation dynamics. In addition, the generalized version of the hybrid NKPC fits the data better than the original hybrid NKPC in terms of various measures for empirical performance such as AIC, BIC, root mean squared error and mean absolute error. JEL classification: E5