KEVIN X.D. HUANG QINGLAI MENG Returns to Scale, Market Power, and the Nature of Price Rigidity in New Keynesian Models with Self-Fulfilling Expectations Increasing returns to scale and firms’ market power are two potential sources of sunspot expectations in neoclassical models. We show that in New Keyne- sian models, returns to scale and market power can have fundamentally dif- ferent implications for broad macroeconomic issues, including self-fulfilling expectations, depending on the nature of price rigidity. Our findings sug- gest that the design of stabilization monetary policy can depend on precise knowledge about the economy’s real and nominal features. Therefore, a clear understanding of the specific economic environment and its relevance to monetary policymaking for ensuring macroeconomic stability can be an integrated part of monetary policy practice. JEL codes: E12, E31, E52 Keywords: returns to scale, market power, price rigidity, self-fulfilling expectations. THE SOURCES OF SUNSPOT EXPECTATIONS unrelated to economic fundamentals have long been studied in macroeconomics. In neoclassical models, two real features pertaining to production technology and market structure, namely, increasing returns to scale and firms’ market power, have been found as potential factors for real indeterminacy of equilibrium and sunspot-driven business cycles.1 In New Keynesian models, the focus has been on implications of nominal features We are grateful to Jang-Ting Guo, seminar participants at the University of California at Riverside, and two anonymous referees of this journal for helpful comments and suggestions. KEVIN X.D. HUANG is a Professor in the Department of Economics at Vanderbilt University (E-mail: [email protected]). QINGLAI MENG is an Associate Professor in the Department of Economics at Oregon State University (E-mail: [email protected]). Received August 25, 2011; and accepted in revised form February 10, 2012. 1. For the former, see Benhabib and Farmer (1994, 1996), Farmer and Guo (1994), Wen (1998), and Benhabib and Wen (2004), among others. For the latter, see the survey by Schmitt-Grohe´ (1997). Journal of Money, Credit and Banking, Vol. 46, No. 2–3 (March–April 2014) C 2014 The Ohio State University 294 : MONEY, CREDIT AND BANKING pertaining to price rigidity and monetary policy for multiple equilibria and sunspot- driven fluctuations. We study the interactions of these real and nominal features. The general thesis of this paper is that these real features can have fundamentally different implications for macroeconomic dynamics in New Keynesian models, depending on the nature of nominal price rigidity. To help demonstrate this point, we make use of two canonical sticky price models, the Rotemberg (1982) model of costly price adjustment and the Calvo (1983) model of partial price adjustment, which are commonly viewed as iden- tical up to a linear approximation. We find that although the linearized equilibrium systems of the two models are alike in their reduced forms, as similarly demonstrated by Benhabib, Schmitt-Grohe, and Uribe (2000, 2001), among others, structural fun- damentals pertaining to the underlying production technology and market structure affect the elasticity of nominal price inflation with respect to real marginal cost in fundamentally different ways across the two types of stickiness. This gives rise to a different linkage from the structural fundamentals to the slope of the reduced-form Phillips curve, depending on whether price rigidity is modeled one way or another. We analyze in some depth the differences in this connection across the two models and their causes, which can have broad implications for inflation and other aggregate dynamics. While these differences hold in the general context of model specifications and can be relevant for a wide range of macroeconomic issues, we focus our attention in this paper on one important issue, that is, their implications for self-fulfilling expectations and sunspot-induced macroeconomic instability. To this end, we make use of these two models with a flexible forward-inflation targeting policy, under which the mon- etary authority sets nominal interest rate in response to variations in expected future inflation and current output. This makes it particularly convenient for one to digest our discrete-time analysis in the light of the local indeterminacy analysis of Benhabib, Schmitt-Grohe, and Uribe (2000, 2001) that is conducted in continuous time, where the monetary authority sets a nominal interest rate as a function of the instantaneous rate of inflation, since, as is now well known, the instantaneous rate of inflation in a continuous-time setting is the right derivative of the logged price level and, thus, the discrete-time counterpart of a continuous-time policy rule that sets the interest rate in response to the instantaneous rate of inflation is characterized by forward-looking policy that responds to expected future inflation.2 Further, as is also well known, forward-inflation targeting is prone to real indeterminacy of equilibrium, and, thus, the contrasts between the different implications of those real features of the economy for sunspot expectations under the two types of nominal rigidities are quantitatively strik- ing with forward-looking policy. But, most importantly, forward-inflation targeting is justified on the ground of both policy effectiveness and central bank accountability 2. See, for example, Obstfeld and Rogoff (1995, p. 522, footnote 10) for an enlightening discussion of this point. KEVIN X.D. HUANG AND QINGLAI MENG : 295 and credibility.3 On the other hand, a flexible targeting rule, which allows the nominal interest rate to respond not only to expected future inflation, but also to other endoge- nous variables, such as current output, is crucial for avoiding policy-induced macroe- conomic instability.4 This is why such a flexible inflation-forecast targeting procedure has been advocated by many researchers5 and has become a dominant framework for monetary policymaking at central banks around the world.6 This is to say that the kind of monetary policy considered in this paper is of paramount practical interest. We show that both the degree of returns to scale in production (including not only increasing but also constant and decreasing returns to scale) and firms’ market power can have exact opposite implications for macroeconomic stability in the Rotemberg model than in the Calvo model. Here, we summarize our results briefly. First, in the Calvo model, increasing returns to scale is a potential source of sunspot expectations,7 as in the real models, whereas decreasing returns to scale or fixed factors is potentially a stabilizing factor for the economy. In the Rotemberg model, by contrast, it is decreasing returns to scale or fixed factors that is a potential source of self-fulfilling expectations, whereas increasing returns to scale may actually be a stabilizing factor for the economy. Second, in the Calvo model, firms’ market power is a potential source of sunspot-driven fluctuations, as in the real models, provided that production technology exhibits decreasing returns to scale or fixed factors, while such market power may actually be a stabilizing factor if production technology exhibits increasing returns to scale. In the Rotemberg model, by contrast, market power of firms is a stabilizing factor for the economy regardless of the degree of returns to scale in production technology. We show these contrasts analytically for the case with labor as the only productive input and numerically for the case with endogenous capital accumulation. We show that these contrasts continue to hold in the presence of policy inertia in the form of interest rate smoothing, which is considered an 3. See, among others, Svensson (1997), Bernanke and Woodford (1997), Batini and Haldane (1999), Levin, Wieland, and Williams (2003), Orphanides and Williams (2003), and Bernanke and Woodford (2004). 4. See, among others, Clarida, Gal´ı, and Gertler (1998, 1999), Christiano and Gust (1999), Rotemberg and Woodford (1999), Woodford (1999, 2003), Levin, Wieland, and Williams (2003), Kurozumi and Zandweghe (2008), and Huang, Meng, and Xue (2009). 5. See, among others, Svensson (1997, 1999), Svensson and Woodford (2004), and Goodhart (2001). 6. This policy practice started in the industrial and middle-income countries in the late 1980s (see, e.g., Leiderman and Svensson 1995, Bernanke and Mishkin 1997, Bernanke et al. 1999), and spread to the transition and emerging-market economies in the late 1990s (see, e.g., Schaechter, Stone, and Zelmer 2000, Jonas and Mishkin 2004, Roger and Stone 2005), with more moving toward this direction. Indeed, while the U.S. Federal Reserve, the European Central Bank, and the Bank of Japan are usually viewed as having followed some implicit inflation-forecast targeting procedures, estimated forward-looking interest rate feedback rules explain well the behavior of interest rates in the U.S., Germany, and Japan (see, e.g., Chinn and Dooley 1997, Clarida and Gertler 1997, Clarida, Gal´ı, and Gertler 1998, Orphanides 2000, Orphanides and Williams 2003, Carare and Stone 2006). 7. Xiao (2008) and Huang and Meng (2009) also use the Calvo model to analyze the implications of increasing returns to scale for macroeconomic stability under alternative interest rate policy rules, and Weder (2006) conducts a similar analysis in a monetary model with flexible prices. In a monetary model with a constant returns to scale technology and labor as the only productive input, Weder (2008) shows how the Calvo price setting may reduce the scope of indeterminate equilibria under a constant money supply rule. 296 : MONEY, CREDIT AND BANKING important ingredient in monetary policy practice (see, e.g., Sack 1998, Kozicki 1999, Clarida, Gal´ı, and Gertler 2000, Orphanides 2000, Levin, Wieland, and Williams 2003, Christiano, Eichenbaum, and Evans 2005, Levin et al. 2005). These results obtained in the canonical models may convey broad implications. Understanding these implications may be important for the monetary policy practices of central banks that aim to preempt sunspot expectations and fluctuations unrelated to economic fundamentals.