Kinked Demand Curves, the Natural Rate Hypothesis, and Macroeconomic Stability
46 Pages Posted: 15 Jan 2014 Last revised: 13 Feb 2015
Date Written: February 2015
In the presence of staggered price setting, high trend inflation induces a large deviation of steady-state output from its natural rate and indeterminacy of equilibrium under the Taylor rule. This paper examines the implications of a ''smoothed-off'' kink in demand curves for the natural rate hypothesis and macroeconomic stability using a canonical model with staggered price setting, and sheds light on the relationship between the hypothesis and the Taylor principle. An empirically plausible calibration of the model shows that the kink in demand curves mitigates the influence of price dispersion on aggregate output, thereby ensuring that the violation of the natural rate hypothesis is minor and preventing fluctuations driven by self-fulfilling expectations under the Taylor rule.
Keywords: Smoothed-off kink in demand curve, Trend inflation, Price dispersion, Natural rate hypothesis, Taylor principle
JEL Classification: E31, E52
Suggested Citation: Suggested Citation