The Importance of Production Networks and Sectoral Heterogeneity for Monetary Policy

Abstract In this paper I develop a multi-sector model with price frictions, production networks, trend inflation and different types of shocks to study how these conditions affect the properties of inflation and their implications for monetary policy. Calibrating the model to the U.S. economy my results show that in this setting inflation becomes 30% less sensitive to the output-gap compared to a standard one-sector model. Furthermore, in the multi-sector model inflation is affected by sectoral variables linked to between-sector and within-sector price distortions. This fact adds inertia to the inflationary process and makes monetary policy less effective. Additionally, the welfare costs of trend inflation increase by one order of magnitude in the multi-sector model compared to the standard one-sector model. The amplification is quantitatively explained by between-sector rather than within-sector price distortions. This suggests that one-sector models and models without heterogeneity underestimate the costs of long-run inflation and the efficacy of monetary policy to fight inflation.