From Linear to Nonlinear: Rethinking Inflation Dynamics in the Calvo Pricing Mechanism

Katrin Rabitsch-Schilcher, Aleš Maršál and Lorant Kaszab

No 350, Department of Economics Working Paper Series from WU Vienna University of Economics and Business

Abstract: Modern macroeconomics is increasingly leaning towards nonlinear solution methods. Our paper addresses the importance of nonlinearities in price setting. We demonstrate how nonlinearity in endogenous price adjustments, due to misalignments in relative prices, can trigger a price dispersion inflation spiral. This phenomenon yields globally unstable dynamics, even in instances where the model is locally stable around the non-stochastic steady state. We introduce the concept of the stability region as a nonlinear counterpart to the determinacy region. Our findings indicate that in a nonlinear world, the Taylor principle alone does not guarantee inflation stability and stable macroeconomic model moments. This new understanding not only challenges the conventional wisdom on inflation stabilization but also underscores the urgency for recalibrating monetary policy strategies in response to these dynamics.

Keywords: determinacy; stability; price dispersion; monetary policy; nonlinear solution methods; macro-finance (search for similar items in EconPapers)
Date: 2023-09
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Working Paper: From Linear to Nonlinear: Rethinking Inflation Dynamics in the Calvo Pricing Mechanism (2023)
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Persistent link: https://EconPapers.repec.org/RePEc:wiw:wus005:46498408

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