Inflation, Output, and Markup Dynamics with Forward-Looking Wage and Price Setters

Abstract

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.

The Missing Link: Monetary Policy and the Labor Share

“…We analyzed a version of the Christiano, Eichenbaum, and Evans (2005) model with working capital. However, because this channel is amplified when there are firm networks and the working capital channel extends to all inputs in production, we used the model by Phaneuf, Sims, and Victor (2015) which we label NK WKN. 40 Finally, we consider a medium scale DSGE model with labor market frictions and alternate offer bargaining developed by Christiano, Eichenbaum, and Trabandt (2016) (labeled NK SM).…”

Business Cycles, Investment Shocks, and the "Barro-King" Curse

“…Moreover, Cogley and Sbordone (2008) find no evidence of price indexation to the previous period's rate of inflation when combining sticky prices with time-varying trend inflation. Therefore, indexation has been omitted from the late New Keynesian models of Christiano, Trabandt, and Walentin (2010), Trabandt (2015, 2016), Ascari, Phaneuf, and Sims (2015) and Phaneuf, Sims, and Victor (2015). As in these models, the presence of FN is able to generate realistic inertia in inflation, without the unrealistic assumption of backward-looking indexation.…”