Non-homothetic Preferences and the Demand Channel of Inflation

The post-pandemic rise in global inflation has renewed interest in the relative roles played by demand and supply factors in determining prices. Many central banks have stressed the joint role that persistent increases in input costs and excess demand played in boosting inflation in 2021 and 2022. Yet the latter influence plays no independent role in the workhorse New Keynesian models used by many central banks. Under the typical assumption of constant elasticity of substitution (CES) preferences, variations in consumption shift the firm’s profit function up and down, but do not influence its curvature. As a result, the optimal markup is not a function of demand. This assumption is contradicted by both evidence about household shopping behaviour and survey evidence about how firms set prices. This paper proposes an alternative structure based on non-homothetic household preferences over varieties of consumption goods. Specifically, the elasticity of substitution between goods is state dependent, declining during periods of strong per-capita consumption and vice versa. This captures the stylized fact that individual consumers are less price sensitive during economic booms and more price sensitive during downturns. These substitution effects in turn give the firm an incentive to adjust its markup in response to consumption demand. In aggregate, this generates desired markups that increase nonlinearly in consumption demand. When strategic complementarities in pricing are present, these preferences also give rise to state-dependent pass-through of cost shocks. A New Keynesian sticky price model featuring non-homothetic preferences is estimated on Canadian data, and strong evidence favouring a direct role for per-capita consumption demand is presented. This model is better able to capture the increase in core inflation that occurred in 2021–22, particularly when simulated in its nonlinear form.