Fair pricing and inflation inertia

The purpose of the first chapter is to demonstrate the theoretical relevance of fair pricing in explaining inflation and output persistence. Insofar as consumers rely on past prices when they judge price-fairness, prices that are expensive relative to the past will cause consumers to reduce their purchases beyond what is implied by the standard price effect. Realizing the potential fall in demand resulted from marking up prices too fast, price setters will prefer to smooth price changes by varying the markup. This form of countercyclical markup is shown to generate a substantial degree of inflation inertia and a gradual response of inflation to monetary policy shocks, even in the absence of other forms of nominal rigidities. The second chapter incorporates fair pricing into the standard New Keynesian framework to investigate whether the behavioral friction induced by the fair pricing can generate a hybrid Phillips curve. Recent New Keynesian theories have justified the existence of a hybrid Phillips Curve by relying on supply-driven nominal rigidities to motivate a forward looking pricing behavior, while relying on other supply frictions-such as backward looking indexation, sticky information or irrational expectations-to motivate an additional backward pricing component. This chapter offers an alternative explanation for the existence of a backward looking pricing behavior by accounting for the existence of a demand-driven nominal rigidity, in which purchasing behavior is influenced by consumers' concern about price fairness. To the extent that consumers evaluate price fairness in relation to past price-experience of similar transactions, consumers' demand becomes sensitive to the way prices are adjusted relative to recent price trends. An unusual price rise will be perceived by consumers as unfair and generate a demand reduction beyond the standard price effect, as consumers seek to limit their disutility from being 'ripped off'. Alternatively, an unusual price fall will be perceived by consumers as fairer and generate a demand increase beyond the standard price effect, as consumers seek to enhance their level of satisfaction from having a 'bargain'. Acknowledging the adverse 'unfairness' consequences of adjusting prices too fast, price setters will seek to dampen shocks to marginal costs by endogenously setting optimal markups in a countercyclical fashion. This mechanism is shown to generate firm-specific inflation inertia, and an overall inflation stickiness. Together with the standard theories of nominal rigidities, this model offers an alternative explanation for the existence of a hybrid Phillips Curve; the forward looking component represents the supplier's objective to set a price that is in-line with present and future marginal costs, while the backward looking component reflects the desire of price setters to maintain a good costumer relations by adjusting prices in a 'fair' manner. In chapter 3 we investigate the impact of production lags on inflation stickiness. We model production lags by assuming a two stage production specification where the first stage is initiated one period in advance of sales. Our results are consistent with Lindbeck and Snower (1999) who argues that production lags alone cannot generate inflation inertia and a real effect of monetary policy.