By Maria Ferrara and Patrizio Tirelli
http://d.repec.org/n?u=RePEc:mib:wpaper:305&r=all
We investigate the redistributive effects of a disinflation experiment in an otherwise standard medium-scale DSGE model augmented for Limited Asset Market Participation, implying that a fraction of households do not hold any wealth. We highlight two key mechanisms driving consumption and income distribution: i) the cash in advance constraint on firms working capital needs; ii) the response of profit margins to disinflation, which is crucially dependent on the two most used pricing assumptions in the New-Keynesian literature, i.e. Calvo vs Rotemberg. Results show that disinflation softens the cash in advance constraint and raises the real wage in steady state. This, in turn, lowers inequality. While under the Calvo formalism this effect is reinforced by the fall of price markups, under Rotemberg it is more than compensated by the increase of price markups and, therefore, the opposite result obtains.
There are two lessons I learn from this paper: the standard price adjustment processes in the literature are seriously ill-equipped to help us with disinflation, and we know very little about the distribution impact of disinflation. This is all likely worse with deflation. Now that the latter has become the reality in several countries, and possibly for a longer time, macro theory has its work cut out.
NEP-DGE Blog 