Trend Inflation, Firm-Specific Capital, and Sticky Prices

27 Pages Posted: 6 Dec 2012

See all articles by Andreas Hornstein

Andreas Hornstein

Federal Reserve Bank of Richmond

Alexander L. Wolman

Federal Reserve Bank of Richmond

Date Written: 2005

Abstract

Early empirical studies of the New Keynesian Phillips Curve imply implausibly high levels of price stickiness for standard monetary models with Calvo-type nominal rigidities. More recently researchers have found that the addition of real rigidities through firm-specific capital adjustment costs allows for a reinterpretation of estimated New Keynesian Phillips Curves that makes the implied price stickiness more plausible. A common assumption in the literature on economies with Calvo-type nominal rigidities is that the economy fluctuates around a zero-inflation steady state. While average inflation has been low in the recent past, it certainly has not been zero. We study the impact of nonzero average inflation in an alternative model of nominal rigidities, namely Taylor-type staggered pricing with firm-specific capital adjustment costs. We find that in this alternative framework, the widely accepted Taylor principle is no longer sufficient to guarantee that monetary policy does not become a source of unnecessary fluctuations. In particular, we find that for low values of average inflation, a central bank has to increase nominal interest rates by substantially more than one-for-one in response to an increase of inflation. This finding suggests caution in interpreting models that impose the zero steady-state inflation rate assumption.

Suggested Citation

Hornstein, Andreas and Wolman, Alexander L., Trend Inflation, Firm-Specific Capital, and Sticky Prices (2005). FRB Richmond Economic Quarterly, vol. 91, no. 4, Fall 2005, pp. 57-83. Available at SSRN: https://ssrn.com/abstract=2185569

Andreas Hornstein (Contact Author)

Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States
804-697-8266 (Phone)
804-697-8255 (Fax)

Alexander L. Wolman

Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

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