Price Stability and Endogenous Productivity

I present a model, where firms’ markups are endogenous and are a function of the level of price stability in an economy. Because price signals are noisier in periods of unstable inflation, firms’ market power is higher in such periods. By raising their profits, this permits the survival of low productivity firms, thereby reducing aggregate productivity. By contrast, in periods of price stability, firms have less pricing power, and this reduces their markups and profits. As a result, more productive firms survive, while less productive ones either fail or must effect efficiency gains. Overall, the model predicts a negative relationship between productivity and inflation, which is a robust finding in the data, and which has been a notable feature of recent recessions. ∗Email: [email protected]