Inflation Dynamics with Bounded Rationality

Abstract

There is an unbalanced specification in the standard new Keynesian model.
In the model, stickiness is assumed in the price setting, and then an
individual firm has a fixed probability to change its price in any given
period, which means that the market is imperfect. On the other hand, an
individual firm is assumed to be one that can conduct profit maximization
and calculate the degree of nominal rigidity in the future completely. In
order to avoid this unbalanced specification, we suppose that firms choose
the price with bounded rationality. Concretely, we assume that firms refer to
lagged inflation in the price setting, which is one of the simplest forms to
express bounded rationality. We then obtain the hybrid new Keynesian
Phillips curve to express inflation dynamics, named the sticky price with
bounded rationality Phillips curve (SPBR).