Real Marginal Cost Research Articles

A Factor‐Augmented New Keynesian Phillips Curve for the European Union Countries

AbstractIn this paper, a factor‐augmented version of the New Keynesian Phillips curve (NKPC) is assessed using a data set comprised of a large panel of European Union (EU) member countries. The factor‐augmentation is natural given that country‐level inflation rates are highly co‐moving. The presence of unattended common factors is important because it raises the issue of omitted variables bias, as the real marginal cost, which is a regressor of the NKPC, is likely to load on the same factors as inflation. One possibility here is to employ the regular instrumental variables approach. However, if the external instruments load on the same factors as the error term of the NKPC, the instruments would be invalid and the results would therefore likely be misleading. Motivated by this last observation, the present paper proposes a new estimator of the NKPC that allows for very general forms of factor dependencies and endogeneity. Our results provide evidence in support of the NKPC, but only after the presence of common factors has been appropriately accounted for.

Inflation dynamics: a traditional perspective

Abstract We derive a traditional Phillips curve (TPC) under the assumption that a fraction of firms sells output at optimal prices, while the other fraction sells at contract prices. Our derivation delivers a pricing mechanism where inflation depends on expected inflation and the real optimal price, which is the real marginal cost. The parameters of this Phillips curve have a clear structural interpretation in much the same way as its new Keynesian counterpart.. Using a Leontief-type technology, our baseline TPC features expected inflation, the labour share, demand pressure and a vector of supply shocks. We estimate this TPC for five developed and five emerging market economies and find that the degree of price rigidity is significant and correctly signed in most of the economies. We conclude that this TPC is a credible rival to its forward-looking new Keynesian counterpart.

Shock-based inference on the Phillips curve with the cost channel

Economists use the New-Keynesian Phillips Curve (NKPC) to understand the drivers of current inflation. We assess the usefulness of different combinations of demand shocks to make inference, using identification-robust procedures, on the parameters of the NKPC augmented with the monetary policy cost channel. Using US data, we find that the effect of expected inflation on current inflation is hard to pin down; and that the impact of real marginal costs on inflation is uncertain. The data also does not strongly support the monetary policy cost channel as a determinant of inflation.

A Theory of Intrinsic Inflation Persistence

AbstractWe propose a novel theory of intrinsic inflation persistence by introducing trend inflation and Kimball (1995)‐type aggregators of individual differentiated goods and labor in a model with staggered price‐ and wage‐setting. Under nonzero trend inflation, the non‐CES (constant elasticity of substitution) aggregator of goods and staggered price‐setting give rise to a variable real marginal cost of goods aggregation, which becomes a driver of inflation. This marginal cost consists of an aggregate of the goods' relative prices, which depends on past inflation, thereby generating intrinsic inertia in inflation. Likewise, the non‐CES aggregator of labor and staggered wage‐setting lead to intrinsic inertia in wage inflation, which enhances the persistence of price inflation. With the theory we show that inflation exhibits a persistent, hump‐shaped response to monetary policy shocks. We also demonstrate that lower trend inflation reduces inflation persistence and that a credible disinflation leads to a gradual decline in inflation and a fall in output.

Inflation and uncertainty in New Keynesian models: A note

This note studies the inflation-uncertainty relationship in a New Keynesian framework with Rotemberg pricing. Inflation in these models can be expressed as the discounted sum of current and expected future real marginal costs. The main point of this note is to highlight that real marginal costs in general equilibrium tend to be a convex function of output. This, ceteris paribus, makes higher uncertainty about future output increase current inflation, which can quantitatively off-set the deflationary effect of uncertainty via the precautionary savings channel (Basu and Bundick, 2017). • Inflation in New Keynesian models is linked to expected future real marginal costs. • Real marginal costs in these models tend to be a convex function of output. • This convexity makes supply uncertainty (via Jensen’s inequality) inflationary.

A new measure of the output gap, inflation dynamics, and the New Keynesian Phillips Curve

Literature suggests that measures of slack such as unemployment, output, labour share, and inflation have been separated in recent years, particularly after the global crisis. Some claimed that the Phillips curve had vanished. Because of the unobservable nature of the natural rates, estimation of the output and unemployment gaps might not offer precise outcomes. The inflation model permits a fraction of firms that use a backwards-looking rule to set prices, as Gali and Gertler (2000) did. The essential contrast between their paper and mine is that they utilized marginal cost estimates as the applicable determinant of inflation, and I utilized the estimated output gap. Gali and Gertler supposed real marginal costs are a significant determinant of inflation. They also believed the output gap was negative and inconsequential. I have indicated that a precise output gap estimate is significant and positive. CBO output gap is also used to inspect for robustness. However, it was also insignificant, as the literature suggests. Therefore, the model used the estimated output gap instead of marginal cost. I calculated the output gap with a new methodology and could replicate their results with the new measure. I extended their study to 2019Q4; It is showed that their measure for inflation slack which was marginal cost becomes insignificant; however, my measure of the output gap is still significant. Therefore, it was inferred that the New Keynesian Phillips curve reasonably still explains inflation dynamics. I also concluded that the hybrid new Keynesian Phillips curve might explain the inflation dynamics.

Asymmetries in monetary policy

Nonlinearities embedded in the standard New-Keynesian model show that a welfare-maximizing policymaker should behave in line with a contractionary bias, fearing more expansions in output and inflation rather than contractions. On the contrary, the aggregate-supply equation implies that any upward pressure coming from real marginal costs does not necessarily push up inflation. Once these two forces are combined in the optimal policy, an overall expansionary bias emerges. The nonlinearities of the AS equation combined with changes in volatility can be responsible for a flattening in the estimated linear Phillips curve.

Market Reforms at the Zero Lower Bound

AbstractThis paper studies the impact of product and labor market reforms when the economy faces major slack and a binding constraint on monetary policy easing—such as the zero lower bound (ZLB). To this end, we build a model with endogenous producer entry, labor market frictions, and nominal rigidities. We find that while the effect of market reforms depends on the cyclical conditions under which they are implemented, the ZLB itself does not appear to matter. In fact, when carried out in a recession, the impact of reforms is typically stronger when the ZLB is binding. The reason is that reforms are inflationary in our structural model (or they have no noticeable deflationary effects). Thus, contrary to the implications of reduced‐form modeling of product and labor market reforms as exogenous reductions in price and wage markups, our analysis shows that there is no simple across‐the‐board relationship between market reforms and the behavior of real marginal costs. This significantly alters the consequences of the zero (or any effective) lower bound on policy rates.

DISCUSSION OF HYBRID NEW KEYNESIAN PHILLIPS CURVE METHODOLOGY ON INFLATION DYNAMICS

The New Keynesian Phillips curve accepts real marginal costs, which are shaped by forward pricing as relevant determinants of inflation. Accordingly, while some firms change prices in every period, the rest of the firms keep prices stable. When fixed prices are considered as the lagged value of inflation, price inertia emerges. In this study, how to reach the hybrid model by technically examining the backward looking expectations as a subset to capture the price inertia in the New Keynesian Phillips curve.

Novokejnzijanska Filipsova kriva i efekti domaćih pokretača inflacije u Republici Srbiji

This study investigates the validity of the New Keynesian Phillips curve in the Republic of Serbia. By means of empirical analysis, the impact of domestic inflation drivers, i.e. inflation expectations, real marginal costs and the output gap, is quantified. The results reveal that inflation in Serbia responds more intensively to negative rather than positive supply and demand shocks as it decreases more significantly in economic contraction than in expansion. The estimated model of the New Keynesian Phillips curve with marginal costs gives the unambiguous evidence that the growth of cost-push inflation could be reduced by a productivity-enhancing policy. Expected inflation significantly impacts the actual inflation rate, albeit inflation dynamics are dominated by inertia, i.e. past rates affect the current. The empirical estimate of the New Keynesian Phillips curve model with the output gap that indicates monetary expansion in the Republic of Serbia might, inter alia, stimulate the economic activity without causing significant inflationary pressures to occur.

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Estimates of the New Keynesian Phillips Curve for Pakistan

This paper presents estimates of the New Keynesian Phillips Curve (NKPC) for the agriculture, manufacturing and services sectors of Pakistan’s economy. The real marginal cost—derived from dynamic translog cost function—labour share of income and output gap are the indicators of economic activity along with past and expected inflation to determine inflation dynamics in each sector. The estimates of the structural parameters of the NKPC are consistent with economic theory in most of the models. Within-sample forecast performance and diagnostic tests indicate that the derived measure of real marginal cost performs better relative to the specifications with labour share of income or output gap. Further, the NKPC based on restrictive Cobb–Douglas production technology with labour input only does not perform better than the models that considers more inputs and intermediate cost. Our results show that the manufacturing is forward-looking sector followed by services and agriculture sectors.

What inflation measure should a currency union target?

What is the appropriate inflation target for the monetary policymaker in a currency union, core inflation or headline inflation? We answer the question in a two-country New Keynesian model with an energy sector. We derive the welfare loss function and find that optimal monetary policy should target output gaps, the terms of trade gap, the Producer Price Index inflation rates, and the real marginal cost gaps. We use the welfare loss function to evaluate two alternative Taylor-type monetary policy rules. We find that the choice of preferred policy rule depends on the shocks. Specifically, when productivity shocks hit the economy, the monetary policymaker should follow the headline inflation Taylor rule, while the core inflation Taylor rule should be followed when a negative energy endowment shock hits the economy. In our extended model in which a representative energy producer in the home country inputs domestic non-energy consumption goods to produce energy to meet the union-wide demands, we also find that the core inflation Taylor rule should be followed when a negative energy productivity shock occurs. In addition, whichever monetary policy rule the monetary policymaker chooses, the welfare level of home households is always lower than that of foreign households following a negative energy productivity shock.

The revealed cost competitiveness of changing trade patterns: A country-sector exercise

In new trade models with heterogenous firms, trade liberalization between high-cost and low-cost countries is expected, all the rest equal, to increase cost competitiveness (i.e., to decrease real marginal costs) relatively more in the former. We report evidence in favour of this prediction for a sample of countries, accounting for about 85% of world trade, from the 1980s to the 2000s. The estimation of the country-sector changes in cost competitiveness (relative to the UK) hinges on taking advantage of the observability of international trade patterns to reveal information on cross-country differences in marginal costs, hence ‘revealed’’ cost competitiveness.

Behavioral Heterogeneity in U.S. Inflation Dynamics

ABSTRACTIn this article we develop and estimate a behavioral model of inflation dynamics with heterogeneous firms. In our stylized framework there are two groups of price setters, fundamentalists and random walk believers. Fundamentalists are forward-looking in the sense that they believe in a present-value relationship between inflation and real marginal costs, while random walk believers are backward-looking, using the simplest rule of thumb, naive expectations, to forecast inflation. Agents are allowed to switch between these different forecasting strategies conditional on their recent relative forecasting performance. We estimate the switching model using aggregate and survey data. Our results support behavioral heterogeneity and the significance of evolutionary learning mechanism. We show that there is substantial time variation in the weights of forward-looking and backward-looking behavior. Although on average the majority of firms use the simple backward-looking rule, the market has phases in which it is dominated by either the fundamentalists or the random walk believers.

Government spending and the exchange rate

This paper studies the real exchange rate response to a government-spending shock in a two-country model with productive government purchases and non-Ricardian households. In this economy, the real exchange rate depreciates following an increase in domestic public spending, consistently with most empirical evidence. Importantly, and consistently with empirical evidence, the depreciation occurs both on impact and in the transition. The transmission mechanism works through an increase in domestic private-sector productivity, spurred by government purchases, which reduces real marginal costs at home allowing for accommodating monetary policy response.

Optimal monetary policy in open economies revisited

This paper revisits optimal monetary policy in open economies, in particular, focusing on the noncooperative policy game under local currency pricing in a two-country dynamic stochastic general equilibrium model. We first derive the quadratic loss functions which noncooperative policy makers aim to minimize. Then, we show that noncooperative policy makers face extra trade-offs regarding stabilizing real marginal costs induced by deviations from the law of one price under local currency pricing, and that optimal monetary policy seeks to stabilize CPI inflation rates and more so under noncooperation than it does under cooperation. As a result of the increased number of stabilizing objectives, welfare gains from cooperation emerge even when two countries face only technology shocks. Still, gains from cooperation are not large, implying that frictions other than nominal rigidities are necessary to strongly recommend cooperation as an important policy framework to increase global welfare.

Peter Drucker Approach: Economic Growth and Transnational Economy of Kingdom of Saudi Arabia

Financial system and technological progress as a productive investments concern about the relationship between the expected real interest rates and outputs because investments have monetary transmission mechanism on the productivity and labor-supply which have effects on outputs, inflations, and the interest rates. But the dynamic general equilibrium model of the real business cycle has the impulse response momentum in the macroeconomic variables including investments, employments, real wages, interest rates, consumptions, the GDP deflators, and GDP. The productive investments with the efficient utilization of capital stock effectively influence the direction of real wages, marginal cost and price formation so the business enterprises and welfare system of the Saudi-Arabia kingdom optimize the real business cycle of the economy with advancements in productivity levels, innovation and technology, and the efficient capital markets.

Working Capital Requirement and the Unemployment Volatility Puzzle

Shimer (2015) argues that a search and matching model of the labor market in which wage is determined by Nash bargaining cannot generate the observed volatility in unemployment and vacancy in response to reasonable labor productivity shocks. This paper examines how incorporating monopolistically competitive firms with a working capital requirement (in which firms borrow funds to pay their wage bills) improves the ability of the search models to match the empirical fluctuations in unemployment and vacancy without resorting to an alternative wage setting mechanism. The monetary authority follows an interest rate rule in the model. A positive labor productivity shock lowers the real marginal cost of production and lowers inflation. In response to the fall in price level, the monetary authority reduces the nominal interest rate. A lower interest rate reduces the cost of financing and partially offsets the increase in labor cost from a higher productivity. A reduced labor cost implies the firms retain a greater portion of the gain from a productivity shock, which gives them a greater incentive to create vacancies. Simulations show that a working capital requirement does indeed improve the ability of the search models to generate fluctuations in key labor market variables to better match the U.S. data.