DP17521 Competition and the Phillips Curve
It has been well-documented that the Phillips curve has flattened, making central bankers wary of the reduced effectiveness of monetary policy to achieve price stability. There has also been a growing concern about higher market concentration and the rising profit margins and markup rates. Are these two events observed in recent years merely coincidental? Or, are they causally related? To address this issue, this paper extends the canonical New Keynesian model by introducing markup-rate changes caused by entry and exit, under Homothetic Single Aggregator (hereafter, HSA), a class of homothetic demand systems, which contain CES and Translog as special cases. We use HSA because its single aggregator summarizes all the impacts of market concentration on the pricing behavior of monopolistically competitive firms, and thus it serves as a sufficient statistic. We show that, under Marshall’s second law of demand (i.e., the price elasticity of demand goes up with its price), market concentration leads to a rise of the markup rate, and that, under the third law of demand (i.e., the rate of increase in the price elasticity goes down with its price), market concentration leads to a decline of the pass-through rate. We demonstrate analytically that these changes in the markup rate and the pass-through rate cause the flattening of the Phillips curve. Furthermore, Marshall’s second law of demand generates the dynamic effect of competition. That is, a change in the number of firms through endogenous entry directly affects inflation rates in the New Keynesian Phillips curve, which can be interpreted as an endogenous cost-push shock.
