reflects the sensitivity of price adjustment to movements in marginal costs. This includes the parameter that governs the frequency of price adjustment. The lower this frequency,the fewer the firms adjusting in any period,and hence the less sensitive inflation will be to marginal cost and the smaller will be K..Also potentially relevant are pricing complementarities that may induce firms to minimize the variation in their relative prices.These pricing complementarities,know in the literature as "real rigidities,"induce firms that are adjusting prices to want to keep their relative price close to the non-adjusters.The net effect of real rigidities is to reduce k and thus re- duce the overall sensitivity of inflation to output (Ball and Romer (1990) and Woodford(2003)).7 In addition,the cost push shock,ut,has a strict theoretical interpreta- tion.In the absence of market frictions other than nominal price rigidities ut effectively disappears,making yt the exclusive driving force for inflation. Key to this result is that firms are adjusting price in response to expected movements in marginal cost.In this benchmark case,deviations of real marginal cost from its natural value are approximately proportionate to yt, effectively making the latter a sufficient statistic for the former.Roughly speaking,movements in output above the natural level raise labor demand, inducing an increase in wages and and a reduction in the marginal product of labor,both of which tend to raise firms'marginal costs.With other types of market frictions present,however,variation in firms'marginal costs need no longer be simply proportional to excess demand.Suppose,for example,due 7Most of the empirical evidence points to low values for K(Gali and Gertler (1999)). However,with real rigidities present it is possible to reconcile the low estimates with the microeconomic evidence on the frequency of price adjustment,as recently summarized in Steinsson and Nakumura(2007),among others. 14
reáects the sensitivity of price adjustment to movements in marginal costs. This includes the parameter that governs the frequency of price adjustment. The lower this frequency, the fewer the Örms adjusting in any period, and hence the less sensitive ináation will be to marginal cost and the smaller will be .. Also potentially relevant are pricing complementarities that may induce Örms to minimize the variation in their relative prices. These pricing complementarities, know in the literature as ìreal rigidities,î induce Örms that are adjusting prices to want to keep their relative price close to the non-adjusters. The net e§ect of real rigidities is to reduce and thus reduce the overall sensitivity of ináation to output (Ball and Romer (1990) and Woodford (2003)).7 In addition, the cost push shock, ut ; has a strict theoretical interpretation. In the absence of market frictions other than nominal price rigidities ut e§ectively disappears, making yet the exclusive driving force for ináation. Key to this result is that Örms are adjusting price in response to expected movements in marginal cost. In this benchmark case, deviations of real marginal cost from its natural value are approximately proportionate to yet ; e§ectively making the latter a su¢ cient statistic for the former. Roughly speaking, movements in output above the natural level raise labor demand, inducing an increase in wages and and a reduction in the marginal product of labor, both of which tend to raise Örmsímarginal costs. With other types of market frictions present, however, variation in Örmsímarginal costs need no longer be simply proportional to excess demand. Suppose, for example, due 7Most of the empirical evidence points to low values for (Gali and Gertler (1999)). However, with real rigidities present it is possible to reconcile the low estimates with the microeconomic evidence on the frequency of price adjustment, as recently summarized in Steinsson and Nakumura (2007), among others. 14
to some form of labor market power,real wages rise above their competitive equilibrium values.Holding constant yt firms'marginal costs increase due to the wage increase,thus fueling inflation.In this instance,the cost push term captures the impact on inflation.More generally,ut encapsulates variation in real marginal costs that is due to factors other than excess demand.In the formulation here we will simply treat ut as exogenous.As we discuss in section 4 and the appendix,however,more general formulations of this model introduce endogenous variation in ut typically by allowing for wage rigidity,introduced much in the same manner as price rigidity (via staggered nominal wage setting.)Indeed,with wage rigidity present,ut,will depend on conventional real shocks such as oil shocks and productivity shocks. Another important way that the new Phillips curve differs from the old is that it is fully forward looking.Inflation depends not only on the current values of yt and ut,but also on the expected discounted sequence of their respective future values.This forward-looking property of inflation implies that a central bank's success in containing inflation depends not only on its current policy stance,but also on what the private sector perceives that stance will be in the future.We elaborate on this in the next section. In the meantime,we note that this forward looking process for inflation contrast sharply with the traditional Phillips curve,which typically relates inflation to lagged values as well as some measure of excess demand,without any explicit theoretical motivation.In the baseline version of the new Phillips curve,arbitrary lags of inflation do not appear.s 8Gali and Gertler(1999)and Gali,Gertler and Lopez-Salido(2005)estimate a hybrid version of the new Phillips curve where inflation depends on both lagged and expected future inflation.Lagged inflation enters because a fraction of firms set prices using a backward-looking rule of thumb.The estimates suggest a weight of roughly.65 on 15
to some form of labor market power, real wages rise above their competitive equilibrium values. Holding constant yet Örmsímarginal costs increase due to the wage increase, thus fueling ináation. In this instance, the cost push term captures the impact on ináation. More generally, ut encapsulates variation in real marginal costs that is due to factors other than excess demand. In the formulation here we will simply treat ut as exogenous. As we discuss in section 4 and the appendix, however, more general formulations of this model introduce endogenous variation in ut typically by allowing for wage rigidity, introduced much in the same manner as price rigidity (via staggered nominal wage setting.) Indeed, with wage rigidity present, ut , will depend on conventional real shocks such as oil shocks and productivity shocks. Another important way that the new Phillips curve di§ers from the old is that it is fully forward looking. Ináation depends not only on the current values of yet and ut , but also on the expected discounted sequence of their respective future values. This forward-looking property of ináation implies that a central bankís success in containing ináation depends not only on its current policy stance, but also on what the private sector perceives that stance will be in the future. We elaborate on this in the next section. In the meantime, we note that this forward looking process for ináation contrast sharply with the traditional Phillips curve, which typically relates ináation to lagged values as well as some measure of excess demand, without any explicit theoretical motivation. In the baseline version of the new Phillips curve, arbitrary lags of ináation do not appear.8 8Gali and Gertler (1999) and Gali, Gertler and Lopez-Salido (2005) estimate a hybrid version of the new Phillips curve where ináation depends on both lagged and expected future ináation. Lagged ináation enters because a fraction of Örms set prices using a backward-looking rule of thumb. The estimates suggest a weight of roughly :65 on 15