DP15551 State-dependent pricing turns money into a two-edged sword

Author(s): Vo Phuong Mai Le, David Meenagh, Patrick Minford
Publication Date: January 2021
Date Revised: January 2021
Keyword(s): Crises, New keynesian, Nominal GDP, price stability, Rational Expectations, State-Dependence
JEL(s): E2, E3
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15551

Strong evidence exists that price/wage durations are dependent on the state of the economy, especially inflation. We embed this dependence in a macro model of the US that otherwise does well in matching the economy's behaviour in the last three decades; it now also matches it over the whole post-war period. This finding implies a major new role for monetary policy: besides controlling inflation it now determines the economy's price stickiness. We find that, when backed by fiscal policy in preventing a ZLB, by targeting nominal GDP monetary policy can achieve high price stability and avoid large cyclical output fluctuations.