The Cost of Tractability and the Calvo Pricing Assumption

Abstract

This paper demonstrates that tractability gained from the Calvo pricing assumption is costly in terms of aggregate dynamics. I derive a generalized New Keynesian Phillips curve featuring a generalized hazard function, non-zero steady state inflation and real rigidity. Analytically, I find that important dynamics in the NKPC are canceled out due to the restrictive Calvo assumption. I also present a general result, showing that, under certain conditions, this generalized Calvo pricing model generates the same aggregate dynamics as the gen- eralized Taylor model with heterogeneous price durations. The richer dynamic structure introduced by the non-constant hazards is also quantitatively important to the inflation dy- namics. Incorporation of real rigidity and trend inflation strengthen this effect even further. With reasonable parameter values, the model accounts for hump-shaped impulse responses of inflation to the monetary shock, and the real effects of monetary shocks are 2-3 times higher than those in the Calvo model.