Testing an alternative price-setting behavior in the new Keynesian Phillips curve: Extrapolative price-setting mechanism

In this paper, we propose an expanded version of the hybrid NKPC by incorporating the extrapolative price-setting mechanism in the backward-looking part. We assume that when firms set the price at time t, they use information on the price in period t − 1 plus a portion of change in prices between t − 1 to t − 2 (a partial error correction). Under this expanded setting, we explicitly derive both structural and reduced-form NKPCs. The empirical results show that the extrapolative component is strongly significant in explaining inflation dynamics. In addition, the expanded version of the hybrid NKPC exhibits a better empirical performance than the original hybrid NKPC proposed by Galí and Gertler (1999) in terms of various statistical criteria.