Title: The demise of the treaty of Detroit and (dis)inflation dynamics
Authors: Isabel Cairo - Federal Reserve Board (United States)
Jae Sim - Federal Reserve Board (United States) [presenting]
Abstract: The implications for inflation dynamics of the decoupling of real wage growth and productivity growth since 1980s is explored through the lens of New Keynesian monetary economics. A canonical New Keynesian Phillips curve predicts that the current inflation rate is determined as the expected present value of future marginal cost, which is nothing but the ratio of real wage relative to productivity in the long run. We study the ability of the monetary authority to achieve its inflation target when the real wage growth is predicted to be stalled for a considerable amount of time. Using a simple New Keynesian model with search and matching frictions, we consider two cases: one in which the monetary authority observes the drivers of the natural rate of unemployment and correctly readjusts its assessment of the natural rate in real time; an alternative environment in which the monetary authority observes only noisy signals and fails to update the natural rate in a timely manner. We show that the misperception of the natural rate in the latter environment may create a systematic linkage among seemingly unrelated tendencies: misperception in the natural rate; disinflationary pressure; rising income inequality; and growing financial instability.