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

Aleš Maršál, Katrin Rabitsch () and Lorant Kaszab
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Katrin Rabitsch: Department of Economics, Vienna University of Economics and Business

Department of Economics Working Papers from Vienna University of Economics and Business, Department of Economics

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)
JEL-codes: E13 E31 E43 E44 (search for similar items in EconPapers)
Date: 2023-09
New Economics Papers: this item is included in nep-ban, nep-cba, nep-mac and nep-mon
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Working Paper: From Linear to Nonlinear: Rethinking Inflation Dynamics in the Calvo Pricing Mechanism (2023)
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