THE PHILLIPS CURVE AND A MICRO-FOUNDATION OF TREND INFLATION
The hybrid New Keynesian Phillips curve has been criticized for lacking a micro-foundation. In this paper, an alternative purely forward-looking model of the Phillips curve is constructed on the basis of a micro-foundation of trend inflation. In addition, another source of output gaps other than frictions―a Nash equilibrium of a Pareto inefficient path―is considered. The model indicates that the role of frictions has been overestimated and that frictions are less important than previously have been thought. The conventional monetary policy of utilizing frictions cannot necessarily stabilize inflation. In contrast, the monetary policy of controlling the government’s preference is very effective. A problem is that the effects of both types of monetary policy are not distinguishable.
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