Firm-Specific Labor, Trend Inflation, and Equilibrium Stability

Abstract

In a Calvo sticky price model based on micro evidence that each period a fraction of prices is kept unchanged, we examine implications of firm-specific labor for determinacy and expectational stability (E-stability) of rational expectations equilibrium under interest rate policy. Firm-specific labor causes higher trend inflation to be more likely to induce not only indeterminacy but also E-instability. The latter is in contrast with the result of E-stability in the case of homogeneous labor analyzed in recent research. Moreover, under the same calibration of structural model parameters, indeterminacy and E-instability are much more likely in the case of firm-specific labor than in the case of homogeneous labor. The recent argument — a decline in trend inflation along with the Fed’s change from a passive to an active policy response to inflation explains much of the U.S. economy’s shift from indeterminacy during the Great Inflation era to determinacy during the Great Moderation era — depends crucially on the assumption of firm-specific labor.