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Trend inflation, firm-specific capital, and sticky prices

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Author Info
Andreas Hornstein
Alexander L. Wolman

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Abstract

Early empirical studies of the New Keynesian Phillips Curve imply implausibly high levels of price stickiness for standard monetary models with Calvo-type nominal rigidities. More recently researchers have found that the addition of real rigidities through firm-specific capital adjustment costs allows for a reinterpretation of estimated New Keynesian Phillips Curves that makes the implied price stickiness more plausible. A common assumption in the literature on economies with Calvo-type nominal rigidities is that the economy fluctuates around a zero-inflation steady state. While average inflation has been low in the recent past, it certainly has not been zero. We study the impact of nonzero average inflation in an alternative model of nominal rigidities, namely Taylor-type staggered pricing with firm-specific capital adjustment costs. We find that in this alternative framework, the widely accepted Taylor principle is no longer sufficient to guarantee that monetary policy does not become a source of unnecessary fluctuations. In particular, we find that for low values of average inflation, a central bank has to increase nominal interest rates by substantially more than one-for-one in response to an increase of inflation. This finding suggests caution in interpreting models that impose the zero steady-state inflation rate assumption.

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Article provided by Federal Reserve Bank of Richmond in its journal Economic Quarterly.

Volume (Year): (2005)
Issue (Month): Fall ()
Pages: 57-83
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Handle: RePEc:fip:fedreq:y:2005:i:fall:p:57-83:n:v.91no.4

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Keywords: Inflation (Finance) Prices

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Blanchard, Olivier Jean & Kiyotaki, Nobuhiro, 1987. "Monopolistic Competition and the Effects of Aggregate Demand," American Economic Review, American Economic Association, vol. 77(4), pages 647-66, September. [Downloadable!] (restricted)
  2. Woodford, Michael, 2005. "Firm-Specific Capital and the New Keynesian Phillips Curve," MPRA Paper 825, University Library of Munich, Germany. [Downloadable!]
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  3. Sbordone, A.M., 1998. "Prices and Unit Labor Costs: a New Test of Price Stickiness," Papers 653, Stockholm - International Economic Studies.
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  4. Martin Eichenbaum & Jonas D.M. Fisher, 2004. "Evaluating the Calvo Model of Sticky Prices," NBER Working Papers 10617, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  5. Tommy Sveen & Lutz Weinke, 2004. "Pitfalls in the Modeling of Forward-Looking Price Setting and Investment Decisions," Economics Working Papers 773, Department of Economics and Business, Universitat Pompeu Fabra. [Downloadable!]
  6. Taylor, John B, 1980. "Aggregate Dynamics and Staggered Contracts," Journal of Political Economy, University of Chicago Press, vol. 88(1), pages 1-23, February. [Downloadable!] (restricted)
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  7. Günter Coenen & Andrew T. Levin, 2004. "Identifying the influences of nominal and real rigidities in aggregate price-setting behavior," Working Paper Series 418, European Central Bank. [Downloadable!]
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  8. Guido Ascari, 2004. "Staggered prices and trend inflation: some nuisances," Macroeconomics 0404029, EconWPA. [Downloadable!]
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  9. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules And Macroeconomic Stability: Evidence And Some Theory," The Quarterly Journal of Economics, MIT Press, vol. 115(1), pages 147-180, February. [Downloadable!] (restricted)
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  10. Timothy Cogley & Argia M. Sbordone, 2005. "A search for a structural Phillips curve," Staff Reports 203, Federal Reserve Bank of New York. [Downloadable!]
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  11. Alexander L. Wolman, 2000. "The frequency and costs of individual price adjustments," Economic Quarterly, Federal Reserve Bank of Richmond, issue Fall, pages 1-22. [Downloadable!]
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  12. Luca Guerrieri, 2002. "The inflation persistence of staggered contracts," International Finance Discussion Papers 734, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  13. Dixit, Avinash K & Stiglitz, Joseph E, 1977. "Monopolistic Competition and Optimum Product Diversity," American Economic Review, American Economic Association, vol. 67(3), pages 297-308, June. [Downloadable!] (restricted)
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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Guido Ascari & Tiziano Ropele, 2007. "Trend Inflation, Taylor Principle and Indeterminacy," Kiel Working Papers 1332, Kiel Institute for the World Economy. [Downloadable!]
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  2. Kevin X. D. Huang & Qinglai Meng, 2007. "Capital and macroeconomic instability in a discrete-time model with forward-looking interest rate rules," Working Papers 07-4, Federal Reserve Bank of Philadelphia. [Downloadable!]
  3. Robert Amano & Kevin Moran & Stephen Murchison & Andrew Rennison, 2007. "Trend Inflation, Wage and Price Rigidities, and Welfare," Cahiers de recherche 0720, CIRPEE. [Downloadable!]
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