Inflation and Misallocation in New Keynesian Models

The New Keynesian framework implies that sluggish price adjustment results in a distorted allocation of resources. We use a simple model to quantify these unobservable distortions, using data that depict the price-setting behavior of firms, specifically the frequency and the size of price changes. We leverage the recent inflation upswing, and granular data provided by PriceStats, to identify a robust structural model of price setting. Our preferred structural model is characterized by a significant component of state-dependent decisions, implying that large cost shocks, like the recent increases in energy prices, incite firms to react more swiftly than usual. Understanding this feature is crucial for interpreting the recent inflation dynamics and to quantify the welfare costs of inflation. Using granular data, as well as data from the ECB PRISMA (Price-setting Microdata Analysis Network) project, we estimate the welfare cost of inflation in the low inflation environment prevalent until 2020 to be about 2.5 percentage points of GDP in the Euro Area. We also estimate that the recent inflationary shock has triggered a temporary increase of the welfare costs, in the order of an additional 2.4 percentage points of GDP.