The effect of capacity constraints on the slope of the Phillips curve

Abstract

Abstract How do capacity constraints affect the slope of the Phillips curve? In particular, do changes in output affect prices by more when firms face more strongly diminishing returns? Intuitively, one may conjecture that the answer is yes. With more strongly diminishing returns, marginal costs increase more when production increases, also raising prices by more. But this intuition is incomplete in models with sticky prices à la Calvo. In the standard New Keynesian model with Calvo pricing frictions, more strongly diminishing returns actually flatten the Phillips curve. The reason is the reluctance of firms who alter their prices to let their prices get too far out of line with the prices set by firms that do not adjust. We explain how the Phillips curve might be amended to avoid this implausible feature, for example, by using Rotemberg pricing or introducing wage stickiness.