Essays on price-setting models and inflation dynamics

This dissertation investigates the empirical validity of several theories on firms' price-setting behavior and the dynamics of inflation. The dissertation consists of two essays.; The first essay, Reassessment of the New Keynesian Phillips Curve: Gross vs. Value-Added Price Inflation, reexamines the new Keynesian Phillips curve based on the distinction between gross price and value-added price inflation. It is shown that a standard new Keynesian Phillips curve can be interpreted as describing the behavior of gross price inflation and, therefore, it is essential to incorporate intermediate input costs in constructing-marginal cost measures. Moreover, from this gross price inflation model, the valued-added price inflation model is derived explicitly, in which the real price of intermediate inputs plays an important role. The new Keynesian Phillips curve is tested using both inflation models. Our results show that (1) the evidence for the new Keynesian Phillips curve is weak for the whole sample period regardless of model specification; (2) in some subsamples, however, especially during high and volatile inflation periods, the evidence becomes stronger for the value-added price inflation model; and (3) the effects on inflation of the real intermediate input prices and the backward-looking behavior of economic agents are substantial.; The second essay, The Empirical Relationship between the Markup, Marginal Cost and Inflation, and Its Implications for Price-Setting Models, studies how inflation responds differently to different types of structural shocks. For this purpose, a structural vector autoregression model is constructed that can identify the effects of shocks to the desired markup, technology and aggregate demand. The model shows that (1) inflation responds immediately to shocks to the desired markup and technology whereas it displays a hump-shaped response to a demand shock; and (2) the gradual response of inflation to a demand shock is caused by an inertial response of marginal cost, not by an inertial response of inflation to changes in marginal cost. These empirical findings imply that inflation itself does not exhibit intrinsic inertia, and thus some sticky price models need not be discarded simply because they fail to generate the hump-shaped response of inflation to a demand shock. The analyses suggest that the reason for the gradual response of inflation to a demand shock should be found by examining elements that affect production cost.