Variable Elasticity Demand and Inflation Persistence

Abstract

Persistent responses of inflation to monetary policy shocks have been difficult to explain by existing models of the monetary transmission mechanism without embedding controversial intrinsic inertia of inflation. Our paper addresses this issue using a staggered price model with trend inflation, a smoothed-off kink in demand curves, and a fixed cost of production. In this model, inflation exhibits a persistent response to a policy shock even in the absence of its intrinsic inertia, because the kink causes a measure of price dispersion, which is intrinsically inertial, to become a key source of inflation persistence under the positive trend inflation rate. {{p}} In addition, output and labor productivity both rise after an expansionary policy shock as in an estimated structural vector autoregression model. Moreover, credible disinflation induces a gradual decline in inflation and a fall in output as observed during the Volcker disinflation era.