Trend inflation meets macro-finance: the puzzling behavior of price dispersion

Lorant Kaszab, Ales Marsal, Katrin Rabitsch

Publication: Working/Discussion PaperWU Working Paper

Abstract

Motivated by recent empirical findings that emphasize low-frequency movements in inflation as a key determinant of term structure, we introduce trend inflation into the workhorse macro-finance model. We show that this compromises the earlier model success and delivers implausible business cycle and bond price dynamics. We document that this result applies more generally to non-linearly solved models with Calvo pricing and trend inflation and is driven by the behavior of price dispersion, which is i) counterfactually high and ii) highly inaccurately approximated. We highlight the channels behind the undesired performance under trend inflation and propose several remedies.
Original languageEnglish
Place of PublicationVienna
PublisherWU Vienna University of Economics and Business
Publication statusPublished - 1 Oct 2020

Publication series

NameDepartment of Economics Working Paper Series
No.304

WU Working Paper Series

  • Department of Economics Working Paper Series

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