A Rational Expectations Model of Optimal Inflation Inertia

This paper presents a monetary model with nominal rigidities and maximizing, rational, forward-looking households, intermediaries and firms. It differs from conventional models in this class in two key respects. First, price (and wage) setters set pricing policies, including an updating rate for future prices, instead of price levels. Second, output fluctuations during the period of a pricing policy are costly to firms. The paper is motivated by some important shortcomings of conventional models, namely their inability to generate inflation inertia, inflation persistence and recessionary disinflations without introducing either an ad-hoc updating rule or learning. While learning is clearly important, we are interested in the contribution that structural rigidities can make in a forward-looking and optimizing model. The model does generate all of the above effects in response to monetary policy shocks. The channel for these effects in the model is the long-run or inflation updating component of firms' pricing policies. This is distinct from another frequently stressed reason for inflation inertia and persistence, a slow response of marginal cost to shocks, which is also present in our model because all components of marginal cost, not just wages, are sticky. In work in progress, we are estimating the model using Bayesian techniques.