Can Supply Shocks Be Inflationary with a Flat Phillips Curve?

Abstract

Not in standard models. With conventional pricing frictions, imposing a flat Phillips curve also imposes a price level that is rigid with respect to supply shocks. In the New Keynesian model, price markup shocks need to be several orders of magnitude bigger than other shocks in order to fit the data, leading to unreasonable assessments of the magnitude of the increase in costs during inflationary episodes. To account for the facts, we propose a strategic microfoundation of shock-dependent price stickiness: prices are sticky with respect to demand shocks but flexible with respect to supply shocks. This friction is demand-intrinsic, in line with narrative accounts for the imperfect adjustment of prices. Firms can credibly justify a price increase due to a rise in costs, whereas it is harder to do so when demand increases. Supply shocks, including productivity shocks, lead to a flexible-price allocation, where inflation rises rapidly and output falls. An output gap ensues only if monetary policy is tightened.

Keywords: Cost-push shocks, shock dependence, price stickiness, output-inflation tradeoff. JEL classification: E31, E52, E58

JEL Classification: E31, E52, E58