Along the New Keynesian Phillips Curve with Nominal and Real Rigidities

Abstract

Abstract: The new Keynesian Phillips curve (NKPC) has become central to monetary theory and policy. A seemingly benign NKPC prediction is that trend shocks dominate price level fluctuations at all forecast horizons. Since the NKPC cycle of the U.S. GDP deflator peaks at each of the last seven NBER dated recessions, support for the NKPC is limited. The authors develop monetary business cycle models that contain different combinations of nominal (sticky-price) and real (labor market search) rigidities to understand this puzzle. Simulations indicate that a model combining labor market search and flexible prices is better able to match actual price level movements than sticky-price models do. This model represents a challenge to claims that sticky prices are a key part of the monetary transmission mechanism. JEL classification: E3, E5 Key words: new Keynesian Phillips curve, sticky prices, labor market search, common trend, common cycle 1. Introduction Of all the comebacks of the 1990s, it seems a revival in Phillips curve research was the least anticipated. Unlike earlier Phillips curve research that focused on aggregate demand shocks, recent work aims to identify inflationary expectations. The way inflationary expectations are formed matters for business cycle theory and monetary policy. For example, a Phillips curve dependent more on forward- than backward-looking expectations allows policymakers to disinflate with few costs. This favorable trade-off appears at odds with empirical evidence and the views of policymakers. Yun (1996) constructs a rational expectations-monetary business cycle model consistent with a revivalist Phillips curve. He assumes monopolistically competitive firms maximize their expected discounted profit stream subject to a sticky price constraint that reflects a nominal rigidity. The solution to the firms' problem can be cast as the new Keynesian Phillips curve (NKPC) in which price expectations are forward-looking and real marginal cost is the fundamental. The forward-looking NKPC implies a present-value (PV) relation for the price level. The NKPC-PV relation predicts that trend shocks dominate price level movements, in the same way the permanent income hypothesis restricts consumption. If the price level has an economically important cycle, it rejects the NKPC null that only trend shocks matter. This paper uses NKPC-PV predictions to ask if a sticky price-nominal rigidity is needed by a dynamic stochastic general equilibrium (DSGE) model to generate a NKPC that mimics its empirical counterpart. A Beveridge and Nelson (1981), Stock and Watson (1988), and Vahid and Engle (1993) common trend-common cycle price level decomposition links the empirical and theoretical NKPCs. Thus, we study a key feature of a Phillips curve: its predictions for price level dynamics. The Beveridge, Nelson, Stock, Watson-Vahid and Engle (BNSW-VE) decomposition of the NKPC provides us with three moments. The moments are (i) the fraction of price constrained firms, (ii) the NKPC common trend-common cycle decomposition, and (iii) the associated forecast error variance decomposition (FEVD). We use these moments to test the implications of the NKPC-PV restrictions for DSGE models. (1) Sample NKPC moments are based on U.S. GDP deflator and nominal unit labor cost data that runs from 1960Q1 to 2001Q4. Our estimate of NKPC moment (i) has about half of final goods firms being price constrained, which is similar to Sbordone (2002), but smaller than those Gali and Gertler (1999) report. The cycle of NKPC sample moment (ii) is economically important because it peaks at each of the last seven NBER dated recessions. NKPC sample moment (iii) shows trend shocks explain 60 percent of price level variation at a forecast horizon of two years. Thus, NKPC sample moments (ii)-(iii) reject the NKPC-PV predictions. We solve and simulate a version of the Yun (1996) DSGE model to understand the sources and causes of NKPC sample moments (i)-(iii). …