Trend inflation , nominal rigidities , and endogenous growth

We study the implications of trend inflation for an economy’s long-run growth rate. To do so, we extend a New Keynesian model to allow for endogenous growth. The defining characteristic of the New Keynesian framework is that inflation and nominal price stickiness together induce relative price dispersion and thus reduce monopoly profits. When the framework is embedded in an endogenous growth model with expanding variety (Romer 1990), the impact on monopoly profits in turn reduces the return to innovation, and a link between inflation and the growth rate emerges. We explore this relationship, relate it to the empirical literature on the growthinflation connection, and quantify its welfare implications. In particular, we show that the costs of positive trend inflation are substantial. Furthermore, we are currently attempting two extensions to environments where these costs are especially pronounced, namely (i) the case where nominal rigidities exist in the labour market and (ii) the case of endogenous growth à la Benhabib, Perli and Xie (1994), where new varieties can complement pre-existing ones. We believe that our focus on nominal price rigidity is novel, as the existing theoretical literature on the link between trend inflation and growth mostly focuses on the trade-off between money holdings and other forms of saving. ∗The views expressed in this paper are those of the authors. No responsibility should be attributed to the Bank of Canada.