924 Monetary Policy, Beliefs, Unemployment and Inflation
Stock and Watson (2002), reviewed above, is an example of this, though it is also
emphasized by Sims and Zha (2006), among others.
18.2.4 The effects of openness
It is also the case that the openness of the economy has become a major pre-
occupation in macroeconomics in general, and this is reflected in recent research
on the NKPM, where there has been very considerable debate about the effects
of changes in the nominal exchange rate and their “pass-through” into domestic
inflation, and this debate continues. At one end of the spectrum comes the so-
called “isomorphism” described by Clarida, Gali and Gertler (2001), where closed-
and open-economy versions of the “canonical” model with complete pass-through
are isomorphic, in the sense that the properties of the model and of its implied
monetary policy rules are the same in each version. In recent contributions this
characterization is rejected and incomplete pass-through is adopted (examples are
Monacelli, 2003, and Engel, 1999, among others). Micro-explanations have been
advanced for this incomplete pass-through, such as pricing to market (PTM) or
the importance of non-traded goods in consumption, as have macro-explanations
such as slow adjustment of prices at the consumer or importer level (see Devereux
and Yetman, 2002, and, for UK applications, Balakrishnan and Lopez-Salido, 2002;
Kara and Nelson, 2003; Herzberg, Kapetanios and Price, 2003; Batini, Jackson and
Nickell, 2005). Unsurprisingly, allowing for non-unitary pass-through fundamen-
tally alters the analysis of monetary policy in an open economy as compared with
the closed economy.
In concluding this section, we note the input that this short review provides
for the applications reported later in the chapter. Following the account of open-
economy issues, an extension of the NKPM to the open economy case is called for;
thus section 18.4 calls on the recent empirical research on international determi-
nants of UK price margins contained in some of the work noted immediately above.
Section 18.4 also builds on some of the contributions emphasizing model uncer-
tainty, especially those of Sargent (1999) and Orphanides and Williams (2006),
when analyzing the effects of monetary policy. The application to the UK reported
in section 18.5 uses a model of the aggregate-supply equation that is econometric,
following the comments made at the end of section 18.2.2. But, before moving to
the application of model uncertainty to the UK case, the next section outlines the
basic Beliefs model which underpins it.
18.3 Beliefs and monetary policy
18.3.1 Motivation
A brief outline of Sargent’s (1999) model is that it is the Kydland and Prescott
(1977) model coupled with the assumption of learning by the authorities, with
the results being directed at accounting for variations in US inflation and unem-
ployment. The fundamental assumption is that the authorities have a misspecified
model of the Phillips curve, but update the parameters of this in the light of pre-
diction errors. The remarkable finding in Sargent, and confirmed in other studies,