Reconsidering the Natural Rate Hypothesis in a New Keynesian Framework

This paper formulates a stylized New Keynesian model in which each individual firm can select the frequency of its price adjustments, and we demonstrate that the endogeneity of the contract structure has a dramatic impact on the magnitude of the aggregate effects of steady-state inflation. We start by analyzing the exact nonlinear properties of a benchmark economy with exogenous contract duration, and we show that the long-run Phillips curve is downward sloping even for very low levels of steady-state inflation. We then proceed to analyze economies in which each firm chooses the mean duration of its price contracts in order to maximize its expected profits; with a plausible calibration of the magnitude of menu costs and other structural parameters, this model predicts a relationship between steady-state inflation and the frequency of price adjustment that is remarkably close to the empirical findings of cross-country studies. Furthermore, at moderate inflation rates, steady-state inflation generates relative price distortions that have a non-trivial impact on aggregate output, but this impact wanes and eventually disappears at much higher annual inflation rates because the frequency of price adjustment approaches that of the flexible-price economy. Finally, we generalize the analysis to allow for heterogeneous menu costs and show that the presence of firms with low menu costs and flexible prices creates a strong motivation for firms with high menu costs to select a contract structure with shorter mean duration. JEL Classification: E31, E52