The investment response to imperfectly credible trade liberalisation with endogenous probability of reversal

Many trade liberalisations and other economic reforms in developing countries, particularly in Africa, have been reversed. In addition to the loss of benefits from reform as such this tendency has led to concern that the response to reform, particularly from investment, may be weakened by the perception that it may be reversed and in turn that weak investment may itself lessen the chances of successful reform. These themes have been discussed extensively in the literature, the current paper's contribution being to develop a much more complete model of the investment response than previously available and to use it to partially endogenise the probability of reform reversal so the two are simultaneously determined. With respect to the reversal probability the argument presented is that a strong investment response in the favoured sector will of itself tend to discourage reversal of the reform (through a lobbying mechanism or simply by the existence of a larger constituency opposed to reversal) while the gradual depreciation of capital in the nonfavoured sector will weaken opposition to reform continuation.

Optimising Microfoundations for Inflation Persistence

We connect two major strands of the recent monetary policy literature, i) the search for well microfounded optimising models consistent with macroeconomic data, especially persistence in inflation, and ii) the wealth of newly available microeconomic data on price changing behaviour from the ECB’s Inflation Persistence Network, alongside earlier firm surveys for the US, UK and Sweden. We develop a fully optimising Phillips curve following Goodfriend and King (NBER Macro Annual,1997) that may be calibrated to virtually any time dependent pricing rule but extended to include cost push shocks and the aggregation of sectors with different pricing rules. Analytical results include a tendency for aggregate dynamics to be driven by “stickier†sectors. When calibrated to micro data the model predicts inflation persistence comparable to that in macro data with fully forward looking underlying pricing behaviourMonetary policy, Phillips curve, Inflation Persistence, Microfoundations

Supply flexibility and insurance under commodity market instability

The paper integrates the analysis of price volatility and supply instability for a commodity exporting country, adding consideration of the role of the non-tradables sector to the literature. The non-tradables sector plays a potentially significant role in changing the economy's response to instability and increases the returns from access to risk markets.

Simple Pricing Rules, the Phillips Curve and the Microfoundations of Inflation Persistence

We analyze the microfoundations of the Phillips curve, a key relationship in general macroeconomics and models of monetary policy in particular. The form in current widespread use includes both forward looking expected inflation and lagged inflation. The presence of lagged inflation is necessary to generate predicted inflation persistence to match actual persistence in real world data but it has proved very difficult to microfound. Recent contributions from Christiano, Eichenbaum and Evans (JPE, 2005) and Gali and Gertler (JME, 1999) have attempted to provide such microfoundations through the assumption of indexing or rule of thumb behaviour. We question the nature of the indexing rules or rules of thumb assumed and re-derive these models for the case where firms choose constrained optimal simple pricing rules. We find that the models no longer convincingly predict inflation persistenceMonetary policy, Phillips curve, Inflation persistence, Microfoundations

The investment response to temporary commodity price shocks

The paper is concerned with the investment response to temporary trade shocks when capital in the commodity and import-competing sectors is irreversible once installed. Previous literature has argued in general terms that investment is likely to rise in response to sharp relative price movements because the return to capital in one of the sectors will increase. A rigorous model of investment under uncertainty in the two-sector commodity price shocks context is developed and used to investigate this issue. It is shown that investment booms in response to commodity price shocks are likely but not certain to occur and a boom at the end of the shock may also be expected. The predictions of the theory are shown to be consistent with the evidence from a small sample of countries during the late 1970s coffee/cocoa boom.

New Keynesian Microfoundations Revisited: A Generalised Calvo-Taylor Model and the Desirability of Inflation vs. Price Level Targeting.

Optimal monetary policy is sensitive to the Phillips curve used to represent the dynamics of inflation and output. Most recent literature has used a New Keynesian Phillips curve based on Calvo pricing. This paper shows that this workhorse model is not robust to relatively minor changes in its microfoundations, in particular allowing for time varying probabilitites of a firm being able to reset its price. We derive a general model that nests Calvo and the Taylor staggering model as special cases and analyse its implications for optimal policy, including the relative desirability of inflation and price level targeting.

Simple Pricing Rules, the Phillips Curve and the Microfoundations of Inflation Persistence

Models in which pricing decisions depend on indexing or rule of thumb behaviour have become prominent in the monetary policy literature and tend to match macroeconomic data well given their prediction of inflation persistence. The extent to which firms index their prices to past inflation has been assumed constant. We explore the consequences of endogenising the degree of indexing such that firms move closer to constrained optimal prices and find that the degree of indexing depends sensitively on firms’ perceptions of the degree of persistence in the economy. This has striking implications. Firstly models in which the degree of indexing is fixed are vulnerable to the Lucas critique since that parameter will change in different regimes. Secondly we study the interactions between perceived persistence, which governs indexing and thus the quantitative significance of lagged inflation in the Phillips curve, and actual persistence which depends on the latter. We find that if firms adjust their indexing behaviour to actual persistence, lagged inflation disappears from the Phillips curve and the models no longer predict persistenceMonetary policy, Phillips curve, Inflation Persistence, Microfoundations, Indexing