Time consistent monetary policy with endogenous price rigidity

I characterize time consistent equilibrium in an economy with price rigidity and an optimizing monetary authority operating under discretion. Firms have the option to increase their frequency of price change, at a cost, in response to higher inflation. Previous studies, which assume a constant degree of price rigidity across inflation regimes, find two time consistent equilibria — one with low inflation, the other with high inflation. In contrast, when price rigidity is endogenous, the high inflation equilibrium ceases to exist. Hence, time consistent equilibrium is unique. This result depends on two features of the analysis: (1) a plausible quantitative specification of the fixed cost of price change, and (2) the presence of an arbitrarily small cost of inflation that is independent of price rigidity. ∗Email: [email protected]. I thank Stefania Albanesi, Roc Armenter, Larry Christiano, Wouter den Haan, Huberto Ennis, Allen Head, Paul Klein, Nooman Rebei, Victor Ríos-Rull, Andreas Schabert, Alex Wolman, workshop participants at the Bank of Canada, UBC, UT Austin, Washington, Columbia, the 2004 Vienna Macro Workshop, the 2004 CMSG Meeting, the 2005 SED Meeting, the 2005 NBER Summer Institute, and especially Mick Devereux, Francisco Gonzalez, and Ed Nosal for helpful discussion and comments. Research funding from the SSHRC is gratefully acknowledged. The views expressed herein are those of the author and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.