Inflation Inertia - the Role of Multiple, Interacting Pricing Rigidities

Abstract

Monetary models with nominal rigidities are known to have difficulties in matching some important features of the empirical impulse responses of monetary policy shocks, especially inertia of the inflation rate and the hump-shaped responses of consumption, investment and output. To remedy this, the literature has mostly employed a combination of backward-looking price setting and of not always uncontroversial real rigidities. This paper addresses the problem without a need to depart from rational forward-looking price setting in a fully specified microfounded model. While price and wage setters are subject to nominal rigidities, they can choose a more generalprice path than in conventional models. Combined with econometrically identified highly persistent monetary policy shocks, this gives rise to far more persistent inflation and real interest rates. Second, a small number of simple and intuitively appealing real rigidities goes a long way in matching empirical impulse responses for real variables. These are habit persistence in consumption, time to build investment with an initial quadratic capital stock adjustment cost, and a long chain of intermediate input supply relationships, with nominal rigidities cascading from upstream to downstream.