Endogenous Markups in the New Keynesian Model: Implications for Inflation-Output Trade-Off and Welfare

Abstract

This paper extends the standard new Keynesian (NK) model by using the endogenous markup setting a la Kimball (1995). In this setting, consumers' price elasticity of demand for a good is increasing in the good's relative price level, which affects the desired price markup of firms. In the literature, this setting is mainly used to improve the NK models in matching sluggishness of prices in the data. Our paper analyzes the monetary policy implications of the model. It is shown that unlike the cases of real wage rigidity and exogenous markup shocks, the endogenous markup setting does not improve the NK models in generating the inflation-output trade-off. It is also discussed that the optimal monetary policy in this environment is to target the flexible price equilibrium. (C) 2015 Elsevier B.V. All rights reserved.