Endogenous Nominal Rigidities and Monetary Policy

June 2008
Takeshi Kimura^*1
Takushi Kurozumi^*2
Naoko Hara^*3

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Abstract

Recent empirical literature suggests that the degree of nominal rigidities varies over monetary policy regimes. This implies that monetary policy analysis with exogenously given nominal rigidities is subject to the Lucas critique. In a Calvo-style sticky price model, we endogenize nominal rigidities and examine their implications for monetary policy. While some previous studies stress that the frequency of price adjustment changes with a central bank's inflation target, we focus on how this frequency varies in response to changes in policy coefficients of the Taylor rule with a fixed inflation target. We find that a central bank's more aggressive policy response to inflation makes firms less likely to reset their prices. The resulting New Keynesian Phillips curve contains a flatter slope and a smaller variance of disturbances, as observed during the Volcker-Greenspan era. We also find that a central bank's aggressive policy response to inflation can stabilize both inflation and the output gap by exploiting the feedback effects of the bank's policy response on firms' price setting. This supports the good policy hypothesis about the Great Moderation. Finally, we show that changes in the policy coefficients dramatically affect the inflation weight of the social welfare loss function, since this weight increases nonlinearly with the frequency of no price adjustment. To reduce social welfare loss, it is crucial for central banks to take into account that the inflation weight changes endogenously with their policy stances.

JEL classification:
E31; E32; E52

Keywords:
Monetary policy; Endogenous nominal rigidities; Great Moderation

The authors appreciate discussions and comments from Kosuke Aoki, Shin-ichi Fukuda, Hibiki Ichiue, Eiji Maeda, Bennett McCallum, Kazuo Momma, Toshihiko Mukoyama, Tomoyuki Nakajima, Mototsugu Shintani, Etsuro Shioji, Toyoichiro Shirota, Willem Van Zandweghe, Tsutomu Watanabe, and seminar participants at the University of Tokyo and the Bank of Japan. Any remaining errors are the sole responsibility of the authors. The views expressed herein are those of the authors and should not be interpreted as those of the Bank of Japan.

• *1 Financial Markets Department, Bank of Japan
  takeshi.kimura@boj.or.jp
• *2 Research and Statistics Department, Bank of Japan
  takushi.kurozumi@boj.or.jp
• *3 Research and Statistics Department, Bank of Japan
  naoko.hara@boj.or.jp

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