Economic Quarterly

Fall 2005

Trend Inflation, Firm-Specific Capital, and Sticky Prices

Andreas Hornstein and Alexander L. Wolman

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.

Our Research Focus: Inflation and Monetary Policy

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