The long-run output-inflation trade-off with menu costs

June 2008

Abstract

We examine the long-run output-inflation trade-off under the assumption that firms face menu costs and set prices in a state dependent fashion. We argue that these characteristics capture the idea that long-run output-inflation trade-off is driven by (predictable) trend inflation, at least on average.

We find that state dependent pricing implies a non-trivial departure from long-run monetary neutrality in terms of output, and a larger one in terms of utility. This is because trend inflation substantially influences average mark-ups and relative price distortions. We find that price stability is optimal.