Working Paper: CEPR ID: DP8565
Authors: Florin Ovidiu Bilbiie; Ippei Fujiwara; Fabio Ghironi
Abstract: We show that deviations from long-run stability of product prices are optimal in the presence of endogenous producer entry and product variety in a sticky-price model with monopolistic competition in which price stability would be optimal in the absence of entry. Specifically, a long-run positive (negative) rate of inflation is optimal when the benefit of variety to consumers falls short of (exceeds) the market incentives for creating that variety under flexible prices, governed by the desired markup. Plausible preference specifications and parameter values justify a long-run inflation rate of two percent or higher. Price indexation implies even larger deviations from long-run price stability. However, price stability (around this non-zero trend) is close to optimal in the short run, even in the presence of time-varying flexible-price markups that distort the allocation of resources across time and states. The central bank uses its leverage over real activity in the long run, but not in the short run. Our results point to the need for continued empirical research on the determinants of markups and investigation of the benefit of product variety to consumers.
Keywords: entry; optimal inflation rate; price stability; product variety; Ramsey-optimal monetary policy
JEL Codes: E31; E32; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Inflation (E31) | Markups (Y10) |
| Inflation (E31) | Producer Entry (D20) |
| Benefit of Variety (L15) | Market Incentives (D49) |
| Market Incentives (D49) | Producer Entry (D20) |
| Benefit of Variety exceeds Market Incentives (D43) | Optimal Long-run Positive Inflation Rate (E31) |
| Market Incentives exceed Benefit of Variety (D49) | Optimal Long-run Negative Inflation Rate (E31) |
| Price Stability around Non-zero Trend (E31) | Optimal in Short Run (D21) |
| Central Bank's Leverage over Real Activity (E52) | Significant in Long Run (C29) |
| Central Bank's Leverage over Real Activity (E52) | Less Significant in Short Run (E19) |