Can Supply Shocks be Inflationary with a Flat Phillips Curve?

Jean-Paul L’Huillier and Gregory Phelan

No 23-03, Working Papers from Office of Financial Research, US Department of the Treasury

Abstract: Empirical estimates find that the relationship between inflation and the output gap is close to nonexistent—a so-called flat Phillips curve. We show that standard pricing frictions cannot simultaneously produce a flat Phillips curve and meaningful inflation from plausible supply shocks. This is because imposing a flat Phillips curve immediately implies that the price level is also rigid with respect to supply shocks. In quantitative versions of the New Keynesian model, price markup shocks need to be several orders of magnitude bigger than other shocks in order to fit the data, leading to unreasonable assessments of the magnitude of the increase in costs during inflationary episodes. Hence, we propose a strategic microfoundation of price stickiness in which prices are sticky with respect to demand shocks but flexible with respect to supply shocks (Working Paper no. 23-03).

Date: 2023-04-20
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Working Paper: Can Supply Shocks Be Inflationary with a Flat Phillips Curve? (2023)
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