A Theory of Intrinsic Inflation Persistence

Abstract

AbstractWe propose a novel theory of intrinsic inflation persistence by introducing trend inflation and Kimball (1995)‐type aggregators of individual differentiated goods and labor in a model with staggered price‐ and wage‐setting. Under nonzero trend inflation, the non‐CES (constant elasticity of substitution) aggregator of goods and staggered price‐setting give rise to a variable real marginal cost of goods aggregation, which becomes a driver of inflation. This marginal cost consists of an aggregate of the goods' relative prices, which depends on past inflation, thereby generating intrinsic inertia in inflation. Likewise, the non‐CES aggregator of labor and staggered wage‐setting lead to intrinsic inertia in wage inflation, which enhances the persistence of price inflation. With the theory we show that inflation exhibits a persistent, hump‐shaped response to monetary policy shocks. We also demonstrate that lower trend inflation reduces inflation persistence and that a credible disinflation leads to a gradual decline in inflation and a fall in output.