Reconsidering the natural rate hypothesis in a New Keynesian framework

This paper formulates a stylized New Keynesian model in which each individual firm can select the frequency of its price adjustments. The endogeneity of contract duration has a dramatic impact on the magnitude of the aggregate effects of steady-state inflation. With a plausible calibration of the magnitude of menu costs and other structural parameters, this model predicts a relationship between steady-state inflation and the frequency of price adjustment that is reasonably close to the empirical findings of cross-country studies. Furthermore, at moderate inflation rates, steady-state inflation generates relative price distortions that have a non-trivial impact on aggregate output, but this impact wanes and eventually disappears at much higher annual inflation rates because the frequency of price adjustment approaches that of the flexible-price economy.