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Sticky prices, marginal cost, and the behavior of inflation’, Federal Reserve Bank of Richmond Economic Quarterly 85

By Alexander L. Wolman

Abstract

Aprincipal goal of economic modeling is to improve the formulation of economic policy. Macroeconomic models with imperfect competition and sticky prices set in a dynamic optimizing framework have gained wide popularity in recent years for examining issues involving monetary policy. For example, Rotemberg and Woodford (1999b) and McCallum and Nelson (1999) examine the behavior of model economies under a variety of monetary policy rules; Ireland (1995) examines the optimal way to disinflate; and Benhabib, Schmitt-Grohe, and Uribe (forthcoming) and Wolman (1998) study the monetary policy implications of the zero bound on nominal interest rates. 1 Nevertheless, serious questions remain as to whether these models accurately describe the U.S. economy, and therefore as to how one should interpret the results of this research. One criticism of optimizing sticky-price models is that the relationship between output and inflation they generate is inconsistent with the behavior of these variables in the United States. 2 However, recent research by Sbordone (1998) and Galí and Gertler (1999) has breathed new life into these models by shifting attention away from the relationship between output and inflation and toward one between marginal cost and inflation—the latter being a more fundamental relationship in the models. If firms have some market power, as under imperfect competition, the behavior of their marginal cost of production is an important determinant of how they set prices. In turn, the overall price The author thanks Mike Dotsey, Andreas Hornstein, Tom Humphrey, Bob King, Wenli Li, and Pierre Sarte for helpful comments and discussions. This article does not necessarily represent the views of the Federal Reserve Bank of Richmond or any branch of the Federa

Year: 1999
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