Inflation, output and markup dynamics with purely forward-looking wage and price setters

Abstract

Medium-scale New Keynesian models are sometimes criticized for their use of backward-looking wage and price setting mechanisms, and for assuming several types of disturbances, including some that would be difficult to interpret economically. We propose a DSGE model with purely forward-looking wage and price setters and parsimoniously chosen disturbances. Our model emphasizes an interplay between production firms networking and working capital. Firms can use working capital to finance all (or a fraction) of their outlays on production factors, and use the output of other firms as an input in a what is often called a “roundabout” production structure. Our model generates a response of inflation which is mute on impact of a monetary policy shock, but highly persistent and very hump-shaped afterwards. It also yields a large contract multiplier for output, two times larger than the one implied by a model relying on indexation only. We also show that the response of the price markup can be positive on impact of an expansionary monetary policy shock, which differs from the standard countercyclical markup channel emphasized in conventional New Keynesian models. In contrast to models relying on indexation to past inflation, our model produces non-inertial responses of inflation to productivity and investment shocks, a finding which is broadly consistent with the existing VAR evidence.