Abstract
Evidence reveals that real output rises much higher in the low inflation regime than in the high inflation regime. Thus, a nominal demand policy shock affecting aggregate demand will have a bigger effect on real output in the low inflation regime than in the high inflation regime. We find that inflation rises and fluctuates much higher in the high inflation regime than in the low inflation regime, following a nominal demand shock. Evidence confirms the new Keynesian hypothesis, which implies that a demand policy is less effective in countries with high trend inflation and where prices are less rigid.
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Notes
- 1.
The new classical economics suggests that policy intervention should not exist because inflation is costlier than unemployment, and that the short-run Philips curve is very steep and a self-correcting economy works smoothly and quickly. By contrast, the new Keynesian theory suggests that there should be policy interventions, because unemployment is costlier than inflation. In this context, the Philips curve is flat and a self-correcting mechanism is rather slow and unreliable.
- 2.
This follows the new Keynesian hypothesis, which implies that a demand policy is less effective in high-trend inflation, especially where prices are less rigid. In addition, due to nominal rigidities arising from the adjustment costs or staggered contracts, prices do not adjust fully to compensate for the shifts in nominal demand such that changes in the nominal demand have real effect (Sun 2012).
- 3.
Literature points that inflation is either I(0) or I(1).
References
Ball, L., Mankiw, N. G., & Romer, D. (1988). The new Keynesian economics and the output-inflation tradeoff. Brooking chapters on Economic Activity, 1, 1–65.
Ndou, E., & Gumata, N. (2017). Inflation dynamics in South Africa, the role of thresholds, exchange rate pass-through and inflation expectations on policy trade offs. Palgrave Macmillan.
Sun. (2012). Nominal rigidity and some new Keynesian evidence on the new Keynesian theory of the output-inflation trade off. (MPRA Chapter No. 45021).
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Ndou, E., Mokoena, T. (2019). Do Inflation Regimes Affect the Transmission of Positive Nominal Demand Shocks to the Consumer Price Level?. In: Inequality, Output-Inflation Trade-Off and Economic Policy Uncertainty . Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-030-19803-9_21
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DOI: https://doi.org/10.1007/978-3-030-19803-9_21
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