Understanding Post-COVID Inflation Dynamics

IMF Working Papers, January 20, 2023

Source details

Proposes a macroeconomic model with a nonlinear Phillips curve that:
- Has a flat slope when inflationary pressures are subdued.
- Steepens when inflationary pressures are elevated.
The nonlinear Phillips curve arises due to a quasi-kinked demand schedule for goods produced by firms.
The model implies stronger transmission of shocks when inflation is high, generating conditional heteroskedasticity in inflation and inflation risk.
The model can generate more sizeable inflation surges due to cost-push and demand shocks than a standard linearized model.

The model can jointly account for:
- The modest decline in inflation during the Great Recession.
- The surge in inflation during the Post-Covid period.
Because transmission of shocks is stronger at high inflation, inflation and inflation risk become conditionally heteroskedastic.
The model implies the central bank faces a more severe trade-off between inflation and output stabilization when inflation is high.

Monetary policy faces a heightened stabilization trade-off in high-inflation episodes: tighter trade-offs between inflation control and output stabilization.
Nonlinear dynamics imply that policy responses calibrated on linearized models may understate the potential size of inflation surges from cost-push and demand shocks.

Subject: Central bank policy rate, Demand elasticity, Economic theory, Financial services, Inflation, Interest rate floor, Monetary policy, Output gap, Prices, Production
Keywords: Central bank policy rate, cost-push shock, Demand elasticity, Global, Inflation, Inflation dynamics, inflation risk, inflation-output gap trade-off, Interest rate floor, linearized model, monetary policy, nonlinear model, nonlinear Phillips curve, Output gap, real rigidities