Understanding Post-COVID Inflation Dynamics

We propose a macroeconomic model with a nonlinear Phillips curve that has a flat slope when inflationary pressures are subdued and steepens when inflationary pressures are elevated. The nonlinear Phillips curve in our model arises due to a quasi-kinked demand schedule for goods produced by firms. Our model can jointly account for the modest decline in inflation during the Great Recession and the surge in inflation post-COVID-19. Because our model implies a stronger transmission of shocks when inflation is high, it generates conditional heteroskedasticity in inflation and inflation risk. Hence, our model can generate more sizable inflation surges due to cost-push and demand shocks than a standard linearized model. Finally, our model implies that central banks face a more severe trade-off between inflation and output stabilization when inflation is high.