Inflation Dynamics in a Dutch Disease Economy

U of Leicester mimeo: In this paper the effect of foreign sector macro-variable on infl‡ation dynamics and firrms' ’pricing behaviour has been investigated in the context of a small open economy New Keynesian Phillips Curve. This curve is derived and estimated for a developing oil-exporting economy sick with Dutch Disease. This version of NKPC is an extention of Leith and Malley’s (2007) small open economy NKPC incorporating oil as a factor of production which is produced in the home country but its price is determined by the world market. Using GMM technique, this curve has been estimated for standard closed and open economy speci…fications of the Iranian economy, that according to the empirical evidence suffers from Dutch Disease. Introducing open economy elements produces three differences in the estimation compared to closed version. First, the degree of price stickiness and the fraction of backward-looking …firms decrease. Second, the degree of substitutability is close to unity. Third, the forward-looking behaviour gains ground while the backward-looking behaviour becomes less important. Moreover, the signi…ficant estimates of the marginal cost coefficient confi…rm the importance of the real marginal cost in explaining in‡flation dynamics in the Iranian economy.