Working Papers

Inflation Distorts Relative Prices: Theory and Evidence

Using a novel identification approach derived from sticky price theories with time or state-dependent adjustment frictions, we empirically identify the effect of inflation on relative price distortions. Our approach can be directly applied to micro price data, does not rely on estimating the gap between actual and flexible prices, and only assumes stationarity of unobserved shocks. Using U.K. CPI micro price data, we document that suboptimally high (or low) inflation is associated with distortions in relative prices that are highly statistically significant. At the aggregate level, fluctuations in inefficient price dispersion are sizable and covary positively with aggregate inflation. In contrast, overall price dispersion fails to covary with inflation because it is mainly driven by trends in the dispersion of flexible prices.  

The Effects of Trend Inflation on Aggregate Dynamics and Monetary Stabilization

I derive a set of new analytic results for the effects of trend inflation on aggregate price and output dynamics in menu cost models. I find that positive trend inflation: (1) induces asymmetry in price and output responses to monetary shocks, (2) leads to price overshooting after large shocks, and (3) overturns the monetary neutrality result for large shocks. Under positive trend inflation, large expansionary monetary interventions lead to output contractions, and smaller expansionary interventions have substantially lower potency. I show that these model predictions are empirically supported by U.S. sectoral data. Calibrating a general equilibrium model to the U.S. economy, I find sizable effects of trend inflation on the effectiveness of monetary stabilization policy. A rise in trend inflation from 2% to 4% increases the economy's sensitivity to an adverse markup shock and worsens the trade-off between price and output stability.  

Understanding Leverage Determinants

The Great Recession induced violent fluctuations in leverage on secured loans and led to adaption of new asset purchase policies by the central banks. To understand the drivers of leverage and the effects of these policies, I set up a general equilibrium model with an endogenous leverage constraint, stemming from agents’ disagreement about the asset value. The model features default in equilibrium and a continuum of borrowing contracts written against the same asset used as collateral. Each contract is traded by a single borrower-lender pair and offers a unique combination of leverage and promised interest. Numerical simulations show that leverage, unlike the price of the asset, is not sensitive to changes in the average optimism of traders but is very sensitive to changes in uncertainty. An asset purchase program that absorbs the risky asset has a positive effect on the asset price but also leads to higher leverage and default risk by distorting the equilibrium sorting of agents into borrowers and lenders.