Microfoundations of Inflation Persistence in the New Keynesian Phillips Curve

Marcelle Chauvet and Insu Kim
CQER Working Paper 10-05
November 2010

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This paper proposes a dynamic stochastic general equilibrium model that endoge­nously generates inflation persistence. We assume that although firms change prices periodically, they face convex costs that preclude optimal adjustment. In essence, the model assumes that price stickiness arises from both the frequency and size of price adjustments. The model is estimated using Bayesian techniques, and the results strongly support both sources of price stickiness in the U.S. data. In contrast with traditional sticky price models, the framework yields inflation inertia, a delayed effect of monetary policy shocks on inflation, and the observed "reverse dynamic" correlation between inflation and economic activity.

JEL classification: E0, E31

Key words: inflation persistence, Phillips curve, sticky prices, convex costs

The authors thank Tao Zha and participants of the 17th Meeting of the Society for Nonlinear Dynamics and Econometrics and of the University of California, Riverside, conference "Business Cycles: Theoretical and Empirical Advances" for helpful comments and suggestions. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to Marcelle Chauvet, Department of Economics, University of California, Riverside, CA 92521, marcelle.chauvet@ucr.edu, or Insu Kim, Institute for Monetary and Economic Research, The Bank of Korea, 110, Namdaemunro 3-Ga, Jung-Gu, Seoul, 100-794, Republic of Korea, insu.kim@email.ucr.edu.

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