Strike while the iron is hot: optimal monetary policy with a nonlinear Phillips curve
Summary
Focus
The recent inflation surge has been accompanied by a significant increase in the frequency of price changes by firms. Traditional economic models of price-setting cannot account for this, as they assume that firms update prices at a constant frequency, irrespective of the inflation level. However, so-called "menu cost" models provide a theory about why firms change their prices at a certain frequency that fits with the available evidence.
Contribution
In this paper, we build a menu cost model and use it to investigate how the fact that firms update prices more often in inflationary environments affects the optimal design of monetary policy. The fact that the frequency of price changes increases with inflation makes prices more flexible, changing the trade-off between inflation and economic activity, increasing the slope of what is known as the "Phillips curve".
Findings
In response to large cost-push shocks, the central bank should follow a "strike while the iron is hot" policy: tighten monetary policy proportionally more aggressively than in response to small shocks. This is because the "sacrifice ratio" is lower in a high inflation environment, meaning that the loss in activity after a monetary policy tightening is reduced as prices become more flexible. The central bank should take advantage of this to avoid excessive inflation volatility.
Abstract
We study the Ramsey optimal monetary policy within the Golosov and Lucas (2007) state-dependent pricing framework. The model provides microfoundations for a nonlinear Phillips curve: the sensitivity of inflation to activity increases after large shocks due to an endogenous rise in the frequency of price changes, as observed during the recent inflation surge. In response to large cost-push shocks, optimal policy leverages the lower sacrifice ratio to reduce inflation and stabilize the frequency of price adjustments. At the same time, when facing total factor productivity shocks, an efficient disturbance, the optimal policy commits to strict price stability, similar to the prescription in the standard Calvo (1983) model.
JEL Classification: E31, E32, E52
Keywords: state-dependent pricing, large shocks, nonlinear Phillips curve, optimal monetary policy
