Low inflation is not perceived as a potential threat to determinacy and macroeconomic stability. Should the Fed return to a rules-based monetary policy, the prospect of indeterminacy would be particularly acute if the Fed adopted a mixed policy rule with the nominal interest rate responding to the output gap and output growth. This is true for a rate of inflation as low as that observed on average since the early 1990s. This finding contrasts sharply with the existing literature where the threat of indeterminacy was high before 1983 and almost nonexistent afterwards. Key to our result is a strong interaction between low trend inflation, sticky wages and technological trend growth. Accounting for a cost channel of monetary policy and a roundabout production process increases the threat of indeterminacy under low inflation. When removing the output gap or output growth from the mixed rule, we find that a rule responding to output growth sharply widens the scope for stability. By stark contrast, the results obtained under a rule reacting to the output gap only essentially mimic those with the mixed rule.
We show that the Calvo price‐setting model is not necessarily inconsistent with evidence of a weak relation between positive trend inflation and price dispersion. We identify the interaction between sticky wages and technical change as factors disrupting the allocative role of the wage system under positive trend inflation. In turn, this interaction generates inefficient wage dispersion, as opposed to price dispersion, which fuels inflation costs. We conclude that it is too early to dismiss the New Keynesian model as a useful vehicle to assess the costs of inflation.
We formulate a medium-scale DSGE model that emphasizes a strong interplay between a roundabout production structure and a working capital channel that requires firms to borrow funds to finance the costs of all their variable inputs and not just the wage bill. Despite an absence of backward-looking price and wage indexation, our model is able to account for (i) a persistent and hump-shaped response of inflation to a monetary policy shock, (ii) a large and persistent response of output to a monetary policy shock, (iii) a mild "price puzzle," (iv) a procyclical price markup conditional on a monetary shock, (v) non-inertial responses of inflation to non-monetary shocks, and (vi) a negative unconditional autocorrelation of the first difference of inflation that is consistent with the data. A medium-scale model relying on backward indexation of wages and prices to past inflation fails along several of these dimensions.
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