Ramsey models featuring flexible-price environments find that optimal inflation is highly volatile and serially uncorrelated. The government has nominal, non-state-contingent liabilities out-standing and, under the Ramsey plan, it uses surprise inflation as a lump-sum tax on financial wealth. Essentially, inflation plays the role of a shock absorber of unexpected innovations in the fiscal deficit (see Chari et. al., 1991; Calvo and Guidotti, 1993; Chari and Kehoe, 1999). Similarly, in Ramsey models with nominal rigidities optimal inflation is still characterized by very little persistence even though it is very stable in such environments (see Schmitt-Grohé and Uribe, 2004b; Siu, 2004). Very little or no persistence results of optimal Ramsey inflation in the literature motivated Chugh (2007) to answer the question originally raised by Chari and Kehoe (1999)- whether there are any general equilibrium settings which rationalize inflation persistence as part of the Ramsey policy. Chugh (2007) introduces capital and habit persistence in preferences in a standard flexible-price Ramsey model and finds that optimal inflation is substantially persistent and highly volatile - even more volatile than the standard flexible-price Ramsey models would suggest.
As the above discussion demonstrates it has proven very difficult to find Ramsey models where inflation is both persistent and stable. The main contribution of this paper is to address this issue by proposing a Ramsey model where optimal inflation has these two properties. In particular, we extend a standard cash-credit good monetary Ramsey model by adding price stickiness and organizational learning-by-doing (LBD) mechanism in the production technology. By delivering a crucial result optimal inflation is characterized by substantial persistence and very low volatility our model fills an important gap in the Ramsey literature.
The basic mechanism regarding organizational learning and knowledge accumulation is that organizations learn from the production process and accumulate this firm-specific knowledge known as organizational capital that raises productivity. One critical feature of this knowledge is that it is produced jointly with output and embodied in the organization itself. To model organizational learning and knowledge accumulation we follow Cooper and Johri (2002) and introduce a firm-level learning-by-doing effect into the production technology. In particular, higher production in any period by a firm leads to the accumulation of organizational capital by the firm. This causes increases not only in productivity in the next period but also in the stock of organizational capital in all future periods. To introduce price stickiness we follow Rotemberg (1982) and assume that firms incur quadratic costs in adjusting their nominal prices.
Our result of stable and persistence Ramsey inflation depends on both learning by-doing and the price stickiness. While learning-by-doing mainly generates the persistence in optimal inflation, price rigidity generates the stability in it. Both of these mechanisms work through the intermediate firms’ optimal pricing condition – namely the New Keynesian Philips Curve. Learning-by-doing influences inflation persistence by introducing a dynamic consideration in the firms’ price setting decision. A current price change not only affects revenue and production today, it also affects knowledge accumulation, productivity, costs and hence profits in all future periods. This dynamic link between current production and future productivity induces the Ramsey planner to use the inflation in a more persistent manner. To make it more intuitive, suppose there is an inflation due to a price increase this period. Firms now have to cut production to match the lower demands. Lower output production this period causes lower accumulation of production knowledge which raise tomorrow’s costs by lowering productivity. Facing higher marginal costs in the next period, the firms set higher prices (which causes inflation again) in the next period as compared to environments without learning-by-doing. By parallel arguments, lower prices (deflation) this period will induce firms to set relatively lower prices in the next period as well. In Chugh (2007) persistence in optimal inflation is generated through a very different mechanism. His result depends on consumption-smoothing. With capital and habit the ability to and preference for consumption-smoothing is enhanced significantly. This generates a persistent real interest rate which implies persistent inflation through the Fisher relationship.
Although, learning-by-doing generates persistence in optimal inflation it can not reduce in-flation volatility by itself. If prices are flexible, there is no real resource cost of price adjustment and the Ramsey planer still finds it optimal to use inflation to synthesize state-contingent returns from nominal risk-free government bonds. When price adjustment costs are introduced to the model, the Ramsey planner faces a tradeoff. On the one hand, the Ramsey planner would like to use surprise inflation because it serves as a non-distortionary instrument to finance innovations in the government budget and thus preferred to changes in distorting proportional labor income tax. On the other hand, the Ramsey planner has strong incentives to stabilize the inflation to minimize the costs associated with inflation changes. As Schmitt-Grohé and Uribe (2004b) and Siu (2004) find, even with a very small degree of price stickiness, this tradeoff is overwhelmingly resolved in favor of inflation stability. When price stickiness is introduced into a LBD model the inflation persistence increases further as compared to a LBD model with flexible prices. The main reason for this is that in a model with both LBD and price stickiness, the inflation directly depends on past, present, and future values of some variables through the New Keynesian Philips Curve. This generates some extra smoothness in the optimal inflation path.
Download
Organizational Learning and Optimal Fiscal and Monetary Policy
