Phillips Curve and Price-Change Distribution under Declining Trend Inflation

The relationship between the price-setting behaviors at the micro level and the inflation dynamics at the macro level is an underexplored research area. In this paper, we first document that (i) a remarkable shift in cross-sectional price-change distributions at the micro level and (ii) a flattening of Phillips curve at the macro level were simultaneously observed in Japan, from the high-inflation periods until the mid-1990s to the low-inflation periods afterward. We, then, empirically show that the menu-cost hypothesis fits the price-setting behavior in Japan and construct a multi-sector general equilibrium model with a higher menu cost in the services sector based on our empirical findings. The quantitative exercise using the model indicates that the above observations at the micro and macro level in Japan can be consistently replicated within a unified model under the declining average inflation and the increasing share of services in output.