Pitfalls in the Modeling of Forward-Looking Price Setting and Investment Decisions
UPF Economics and Business Working Paper 773
22 Pages Posted: 15 Nov 2005
Date Written: September 10, 2004
The present paper makes progress in explaining the role of capital for inflation and output dynamics. We followWoodford (2003, Ch. 5) in assuming Calvo pricing combined with a convex capital adjustment cost at the firm level. Our main result is that capital accumulation affects inflation dynamics primarily through its impact on the marginal cost. This mechanism is much simpler than the one implied by the analysis in Woodford's text. The reason is that his analysis suffers from a conceptual mistake, as we show. The latter obscures the economic mechanism through which capital affects inflation and output dynamics in the Calvo model, as discussed in Woodford (2004).
Keywords: Sticky Prices, Investments
JEL Classification: E22, E31
Suggested Citation: Suggested Citation