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Inflation persistence: how much can we explain?

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  • Pau Rabanal
  • Juan F. Rubio-Ramirez

Abstract

Until recently most macroeconomic models in which monetary policy has real effects were based on the assumption that agents in the economy do not use all available information when making a decision. Critics of these models argue that this assumption implies that agents are not rational. ; In response to this criticism, a class of New Keynesian models has recently been proposed. These models combine "old" Keynesian elements with an environment in which agents form their expectations rationally. The simplest version of such models includes only one type of nominal rigidity, either sticky prices or sticky wages-that is, prices or wages that adjust only slowly to market shortages or surpluses. But these simple models have a drawback: They do not seem to be able to reproduce the persistence of inflation observed in the data. ; This article explores whether adding sticky wages to the baseline sticky-price model solves the persistence-of-inflation problem when plausible durations of price and wage contracts are assumed. ; The analysis confirms that the baseline sticky-price model cannot replicate the observed inflation persistence unless an implausible degree of either price stickiness or exogenous nominal interest rate persistence is assumed. The findings also show that a model with both sticky prices and sticky wages can replicate more closely the autocorrelation function of inflation, even with acceptable levels of both price and wage stickiness.

Suggested Citation

  • Pau Rabanal & Juan F. Rubio-Ramirez, 2003. "Inflation persistence: how much can we explain?," Economic Review, Federal Reserve Bank of Atlanta, issue Q2, pages 43-55.
  • Handle: RePEc:fip:fedaer:y:2003:i:q2:p:43-55:n:v.88no.2
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    References listed on IDEAS

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    1. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2000. "Sticky Price Models of the Business Cycle: Can the Contract Multiplier Solve the Persistence Problem?," Econometrica, Econometric Society, vol. 68(5), pages 1151-1180, September.
    2. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," The Quarterly Journal of Economics, Oxford University Press, vol. 115(1), pages 147-180.
    3. Christiano, Lawrence J & Eichenbaum, Martin, 1992. "Liquidity Effects and the Monetary Transmission Mechanism," American Economic Review, American Economic Association, vol. 82(2), pages 346-353, May.
    4. Dutta, Shantanu & Bergen, Mark & Levy, Daniel, 2002. "Price flexibility in channels of distribution: Evidence from scanner data," Journal of Economic Dynamics and Control, Elsevier, vol. 26(11), pages 1845-1900, September.
    5. Erceg, Christopher J. & Henderson, Dale W. & Levin, Andrew T., 2000. "Optimal monetary policy with staggered wage and price contracts," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 281-313, October.
    6. Gali, Jordi & Gertler, Mark, 1999. "Inflation dynamics: A structural econometric analysis," Journal of Monetary Economics, Elsevier, vol. 44(2), pages 195-222, October.
    7. Rabanal, Pau & Rubio-Ramirez, Juan F., 2005. "Comparing New Keynesian models of the business cycle: A Bayesian approach," Journal of Monetary Economics, Elsevier, vol. 52(6), pages 1151-1166, September.
    8. Lucas, Robert Jr, 1976. "Econometric policy evaluation: A critique," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 1(1), pages 19-46, January.
    9. Fuhrer, Jeffrey C & Moore, George R, 1995. "Forward-Looking Behavior and the Stability of a Conventional Monetary Policy Rule," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(4), pages 1060-1070, November.
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    Cited by:

    1. Ravn, Morten O. & Schmitt-Grohe, Stephanie & Uribe, Martín & Uuskula, Lenno, 2010. "Deep habits and the dynamic effects of monetary policy shocks," Journal of the Japanese and International Economies, Elsevier, vol. 24(2), pages 236-258, June.
    2. Kenji Moriyama, 2011. "Inflation Inertia in Egypt and its Policy Implications," IMF Working Papers 11/160, International Monetary Fund.

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    Keywords

    Inflation (Finance) ; Econometric models;

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