Business Cycles, Inflation and Welfare

New York University, New York NY

Investigators

Abstract

This project continues the development of optimization based general equilibrium models that characterize the joint dynamics of output and inflation. This work involves both a positive and normative analysis of monetary policy. Under a previous NSF grant the investigator developed and estimated optimization based models of inflation. This project measures the relative importance of price and wage rigidities for output and inflation dynamics. In addition to providing guidance for structural modeling, the approach leads naturally to a way to quantify the implied efficiency costs of output and inflation variability, in the spirit of recent literature. The project provides new insights into the sources and the costs of business cycles and improves the design of monetary policy, as well as certain fiscal policies. The approach taken begins with a monetary dynamic general equilibrium economy and then introduces certain frictions. Examples include imperfect competition, nominal price and wage rigidities, as well as various financial market frictions. In addition, preference and technological assumptions are introduced that improve the ability of the framework to account for cyclical output and price behavior. A sample includes: habit formation, various forms of adjustment costs on investment, and variable factor utilization. There are now a number of examples where these frameworks have been taken to the data with reasonable empirical success. This project explores the relative importance of the price and wage rigidities that underlie this approach for both output and inflation dynamics. In addition to providing guidance for subsequent structural modeling, the approach leads naturally to a way to quantify the implied efficiency costs of output and inflation variability. If prices and/or wages are less than fully flexible, then the business cycle will produce fluctuations in the efficiency of resource allocation that are mirrored by fluctuations in the gap between the household's marginal rate of substitution between consumption and leisure and the marginal product of labor. This gap, which is called the "inefficiency gap," corresponds to the inverse of the markup of price over social marginal cost. Further, it is possible to decompose this markup into two components: a markup of price over firms' marginal cost and a markup of the wage over the household's marginal rate of substitution. Countercyclical movements in either the price or wage markup, accordingly, produce procyclical movements in the inefficiency gap. Given certain parametric assumptions, it is possible to construct time series measures of the inefficiency gap and to decompose this gap into its price and wage markup components. This is of interest because the gap measure leads naturally to a simple quantitative indicator of the efficiency costs of fluctuations and the decomposition of the markup provides a way to measure the relative importance of price versus wage rigidity in cyclical fluctuations.