Discussion Paper Series 2005-E-18

The Hump-shaped Behavior of Inflation and a Dynamic Externality

Takayuki Tsuruga

This paper develops a model that can explain the hump-shaped impulse response of inflation to a monetary shock. We utilize a New Keynesian (NK) model with sticky prices and wages, variable capital utilization, habit formation for consumption, and adjustment costs in investment, as in Christiano, Eichenbaum, and Evans (2005). However, instead of assuming a backward-looking indexation, which is often utilized to generate inflation inertia, this paper introduces a dynamic externality into the production function of firms. We show that a dynamic externality can explain the observed hump-shaped behavior of inflation even under purely forward-looking nominal rigidities in nominal prices and wages a la Calvo (1983). In addition, we show that in order for inflation to be hump-shaped, sticky wages and variable capital utilization are important as well as a dynamic externality.

Keywords: Inflation; New Keynesian Phillips Curve; Sticky Price Model; Sticky Wages; Variable Capital Utilization; Dynamic Externality

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 2005 Bank of Japan All Rights Reserved.

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