RIETI Fellow Spotlights Contemporary Economic Research Topics

Part Three: Are Price Rigidities Truly Important?

Kobayashi:
This time, I would like to focus on "Inflation Persistence and Flexible Prices" ( International Economic Review 46(1): 245-61) by Robert Dittmar, William Gavin, and Finn Kydland (2005).

In analyzing the effect of monetary policy such as quantitative easing, a certain degree of price rigidity is generally assumed, whereby the primary focus of discussions is typically on the extent that monetary policy can resolve inefficiencies stemming from sticky prices. This is how New Keynesian theories, the current mainstream of monetary policy, are constructed. However, the actual frequency at which prices change at a firm level, as demonstrated by empirical findings, is far greater than the frequency consistent with changes in macroeconomic data (Bils and Klenow 2004). In one attempt to solve this problem, Lawrence Christiano created a model that produces results consistent with macroeconomic data, even when price changes occur as frequently as shown in the firm-level empirical studies, by assuming firm-specific capital in a New Keynesian model.

However, some advocate models that reject outright the very thinking underlying New Keynesian models; that price rigidities are the primary concern. The paper I introduce this time is one such argument.

In short, the paper says that the assumption of price rigidities is unnecessary in explaining the persistent change in the inflation rate (the basis of the Phillips curve) observed in actual data. Instead, Dittmar et al. assume an environment in which productivity shocks are persistent when prices are flexible. When a Taylor Rule-type monetary policy is implemented in this environment, the persistence of production shocks is converted into inflation persistence via induced policy responses. They argue that through this mechanism the Phillips curve relationship, in which the inflation rate moves in tandem with output, arises (as a result of monetary policy). Kydland, one of the authors of this paper, is a leading Real Business Cycle theorist who won the 2004 Nobel Prize in Economics. The paper definitely showed his true colors.

Econo-kun:
Could you explain the model you referred to as rejecting outright the thinking underlying New Keynesian theories?

Kobayashi:
The basic structure of the model is that of Real Business Cycle models. They incorporate money as a time constraint for consumers; an active factor that shortens consumers' shopping time. The greater the (real) money stock held by consumers, the less time they need for shopping, thus the more time they can spend working and participating in leisure activities. The level of money demand is a result of the optimization of this saving in shopping time. (continued...)

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Previous topics
Part Two: A New Understanding of Debt Deflation Theory
http://www.rieti.go.jp/users/kobayashi-keiicio/serial/en/02.html
Part One: Did Deflation Really Cause the Great Depression?
http://www.rieti.go.jp/users/kobayashi-keiicio/serial/en/01.html