SIER Working Paper Series

This paper shows that the requirement for monetary policy to achieve equilibrium determinacy is substantially loosened when price change frequencies are heterogeneous. The result holds both in a simple sticky price model with the constant elasticity of substitution aggregator and no trend inflation and in an extended model with a variable elasticity of substitution aggregator that permits trend inflation at the historical level. With a realistic cross-sectional distribution of the price change frequency, monetary policy can achieve equilibrium determinacy with much weaker responses to inflation. We then revisit the debate on the role of monetary policy in the transition from the Great Inflation to the Great Moderation in the postwar US economy. The evidence that the US economy was subject to self-fulfilling expectations-driven fluctuations in the pre-Volcker period and that the systematic shift in the monetary policy rule has played a decisive role in stabilizing inflation is found to be much weaker than previously concluded in the literature.

Keywords: Heterogeneity in Price Stickiness; Equilibrium Determinacy; Sectoral Relative Price Dispersion; Monetary Policy; Great Inflation;

JEL classification: E12; E31; E43; E52; N12