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Can Supply Shocks be Inflationary with a Flat Phillips Curve?

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  • Jean-Paul L’Huillier
  • Gregory Phelan

Abstract

Empirical estimates find that the relationship between inflation and the output gap is close to nonexistent—a so-called flat Phillips curve. We show that standard pricing frictions cannot simultaneously produce a flat Phillips curve and meaningful inflation from plausible supply shocks. This is because imposing a flat Phillips curve immediately implies that the price level is also rigid with respect to supply shocks. In quantitative versions of the New Keynesian model, price markup shocks need to be several orders of magnitude bigger than other shocks in order to fit the data, leading to unreasonable assessments of the magnitude of the increase in costs during inflationary episodes. Hence, we propose a strategic microfoundation of price stickiness in which prices are sticky with respect to demand shocks but flexible with respect to supply shocks (Working Paper no. 23-03).

Suggested Citation

  • Jean-Paul L’Huillier & Gregory Phelan, 2023. "Can Supply Shocks be Inflationary with a Flat Phillips Curve?," Working Papers 23-03, Office of Financial Research, US Department of the Treasury.
    • Handle: RePEc:ofr:wpaper:23-03
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    References listed on IDEAS

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    1. N. Gregory Mankiw & Ricardo Reis, 2002. "Sticky Information versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 117(4), pages 1295-1328.
    2. Ricardo Lagos & Randall Wright, 2005. "A Unified Framework for Monetary Theory and Policy Analysis," Journal of Political Economy, University of Chicago Press, vol. 113(3), pages 463-484, June.
    3. Cosmin Ilut & Rosen Valchev & Nicolas Vincent, 2020. "Paralyzed by Fear: Rigid and Discrete Pricing Under Demand Uncertainty," Econometrica, Econometric Society, vol. 88(5), pages 1899-1938, September.
    4. Guido Ascari & Luca Fosso, 2021. "The Inflation Rate Disconnect Puzzle: On the International Component of Trend Inflation and the Flattening of the Phillips Curve," Working Paper 2021/17, Norges Bank.
    5. Jordi Galí, 2015. "Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New Keynesian Framework and Its Applications Second edition," Economics Books, Princeton University Press, edition 2, number 10495.
    6. Nakamura, Emi & Steinsson, Jón, 2011. "Price setting in forward-looking customer markets," Journal of Monetary Economics, Elsevier, vol. 58(3), pages 220-233.
    7. Adam Hale Shapiro, 2022. "How Much Do Supply and Demand Drive Inflation?," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, vol. 2022(15), pages 1-06, June.
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    Cited by:

    1. Harding, Martín & Lindé, Jesper & Trabandt, Mathias, 2023. "Understanding post-COVID inflation dynamics," Journal of Monetary Economics, Elsevier, vol. 140(S), pages 101-118.

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    More about this item

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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