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The Cost of Tractability and the Calvo Pricing Assumption

  • Fang Yao
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    This paper demonstrates that tractability gained from the Calvo pricing assumption is costly in terms of aggregate dynamics. I derive a generalized New Keynesian Phillips curve featuring a generalized hazard function, non-zero steady state inflation and real rigidity. An- alytically, I find that important dynamics in the NKPC are canceled out due to the restrictive Calvo assumption. I also present a general result, showing that, under certain conditions, this generalized Calvo pricing model generates the same aggregate dynamics as the gen- eralized Taylor model with heterogeneous price durations. The richer dynamic structure introduced by the non-constant hazards is also quantitatively important to the inflation dy- namics. Incorporation of real rigidity and trend inflation strengthen this effect even further. With reasonable parameter values, the model accounts for hump-shaped impulse responses of inflation to the monetary shock, and the real effects of monetary shocks are 2-3 times higher than those in the Calvo model.

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    Paper provided by Sonderforschungsbereich 649, Humboldt University, Berlin, Germany in its series SFB 649 Discussion Papers with number SFB649DP2009-042.

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    Length: 35 pages
    Date of creation: Sep 2009
    Date of revision:
    Handle: RePEc:hum:wpaper:sfb649dp2009-042
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