Inflation Dynamics and Monetary Policy

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Among the central issues in macroeconomics is the nature of short run inflation dynamics. This question is also one of the most fiercely debated, with few definitive answers available after decades of investigation. At stake, among other things, is the nature of business cycles and what should be the appropriate conduct of monetary policy. In response to this challenge, in recent years important advances have come about in the theoretical modeling of inflation dynamics, but accompanying econometric analysis has been rather limited and the work to date has raised some troubling questions about the existing theory. It is in this context that this project develops and estimates a structural econometric model of inflation, and then studies implications for business cycles and monetary policy.The proposed research builds on some work in progress on inflation dynamics. It also builds on some of the investigators' existing work that explores the implications of the nature of short run inflation dynamics for optimal monetary policy.The research has three main stages. The first stage involves developing and estimating a structural Phillips curve that survives conventional hypothesis testing. Distinctive features of the approach include: (i) the use of real marginal costs as opposed to an output gap measure, as the theory suggests; (ii) extension of the baseline theory to allow for a subset of firms that may use rule-of-thumb pricing; and (iii) identification and direct estimation of the model's primitive parameters. The second stage involves modeling the cyclical behavior of real marginal costs. It is motivated by some preliminary results from the first stage that suggest that the behavior of inflation conditional on the path of real marginal costs is roughly consistent with existing theories that stress forward looking behavior (i.e., we find that rule of thumb behavior is statistically significant but not quantitatively important). Where the theory appears to break down, however, is in characterizing the link between aggregate activity and real marginal costs. Specifically, to the extent they are reasonably characterized by unit labor costs, movements in real marginal costs tend lag output over the cycle, rather than move contemporaneously as much of the existing theory suggests. In this vein, preliminary findings suggest that the output costs of disinflation may be related to sluggish adjustment of real unit labor costs to movements in output, as opposed to arbitrary stickiness in inflation or adaptive expectations. For this reason, the behavior of real marginal costs is studied. The final stage of the project involves integrating the empirical Phillips curve within a complete dynamic general equilibrium framework (with the appropriate rigidities in unit labor costs) and then analyzing the consequences for monetary policy, both from a positive and normative standpoint.