Endogenous Nominal Rigidities and Monetary Policy

Recent empirical literature suggests that the degree of nominal rigidities varies over monetary policy regimes. This implies that monetary policy analysis with exogenously given nominal rigidities is subject to the Lucas critique. In a Calvo-style sticky price model, we endogenize nominal rigidities and examine their implications for monetary policy. While some previous studies stress that the frequency of price adjustment changes with a central bank's inflation target, we focus on how this frequency varies in response to changes in policy coefficients of the Taylor rule with a fixed inflation target. We find that a central bank's more aggressive policy response to inflation makes firms less likely to reset their prices. The resulting New Keynesian Phillips curve contains a flatter slope and a smaller variance of disturbances, as observed during the Volcker-Greenspan era. We also find that a central bank's aggressive policy response to inflation can stabilize both inflation and the output gap by exploiting the feedback effects of the bank's policy response on firms' price setting. This supports the good policy hypothesis about the Great Moderation. Finally, we show that changes in the policy coefficients dramatically affect the inflation weight of the social welfare loss function, since this weight increases nonlinearly with the frequency of no price adjustment. To reduce social welfare loss, it is crucial for central banks to take into account that the inflation weight changes endogenously with their policy stances.