Inflation Persistence: How Much Can We Explain?

Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W Second Quarter 2003 M onetary policy is a controversial topic. Economists are still divided into two factions: those who believe that monetary policy does have real (inflation-adjusted) effects and those who are convinced that it affects only nominal variables, that is, nominal interest rates and prices. Until recently, almost any macroeconomic model in which monetary policy has real effects was based on the assumption that expectations are formed in an adaptative way, implying that agents do not use all available information when making a decision. Critics of these models argue that, given this assumption, agents are not rational and as a result allow the monetary authority to trick them over and over. In response to this important critique, a whole class of models—New Keynesian models—has been recently proposed. These types of models combine “old” Keynesian elements (imperfect competition and short-term nominal rigidities) with a dynamic general equilibrium environment (where prices and quantities are such that markets clear) in which agents form their expectations rationally.1 The idea behind this approach is that when short-term prices are “sticky” or “rigid”—that is, when they adjust only slowly to market shortages or surpluses—a decrease in the nominal interest rate also implies a decrease in the real interest rate. Therefore, the consumption and investment components of aggregate demand increase, implying an increase in output. But over time the excess aggregate demand shifts prices upward, thereby restoring the level of output to its potential. A drawback of the simplest version of such models (in which only one type of nominal rigidity, either sticky prices or wages, is considered) is that it does not seem to be able to reproduce the observed persistence of inflation. The objective of this article is to determine whether adding sticky wages to a basic sticky-price model overcomes this drawback. The analysis shows that this addition “partially” solves the problem. Empirical work at the micro level suggests that the average duration of price and wage contracts is typically three to six quarters. Chari, Kehoe, and McGrattan (1998) find that, in order to match the persistence of output changes to a monetary shock, their model must assume an implausible degree (ten quarters) of price stickiness, even when capital accumulation and adjustment costs of capital are introduced. Fuhrer and Moore (1995) also show that, in a model using a reasonable length of wage contracts, it is not possible to obtain the inflation persistence observed in the data. As Galí and Gertler (1999) point out, these models imply an aggregate supply relationship (the new Phillips curve) that relates current inflation with expectations of future inflation and real unit-labor costs. Hence, the persistence of price inflation in New Keynesian models is driven by the persistence Inflation Persistence: How Much Can We Explain?