The rise of market power and Ramsey-optimal policy implications

Abstract

De Loecker, Eeckhout, and Unger document that since 1980 aggregate markups in the U.S. economy have significantly increased from 21% above cost to 61% now. In light of this evidence, this paper revisits optimal fiscal and monetary policy recommendations of standard New Keynesian models and shows that under empirically relevant calibrations of market power they radically change: the optimal inflation rate becomes significantly positive and its optimal volatility sharply rises. Moreover, inflation behaves like a random walk in response to unexpected fiscal shocks. Thus, price stability ceases to be the optimal policy outcome.