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Inflation Dynamics and Time-Varying Volatility: New Evidence and an Ss Interpretation

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  • Joseph S. Vavra

Abstract

Is monetary policy less effective at increasing real output during periods of high volatility than during normal times? In this paper, I argue that greater volatility leads to an increase in aggregate price flexibility so that nominal stimulus mostly generates inflation rather than output growth. To do this, I construct price-setting models with "volatility shocks" and show these models match new facts in CPI micro data that standard price-setting models miss. I then show that these models imply output responds less to nominal stimulus during times of high volatility. Furthermore, since volatility is countercyclical, this implies that nominal stimulus has smaller real effects during downturns. For example, the estimated output response to additional nominal stimulus in September 1995, a time of low volatility, is 55 percent larger than the response in October 2001, a time of high volatility.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 19148.

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Date of creation: Jun 2013
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Publication status: published as Joseph Vavra, 2013. "Inflation Dynamics and Time-Varying Volatility: New Evidence and an Ss Interpretation," The Quarterly Journal of Economics, Oxford University Press, vol. 129(1), pages 215-258.
Handle: RePEc:nbr:nberwo:19148

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