We propose a general equilibrium model that explains the empirical evidence of the
hump-shaped response of inflation to a monetary policy shock. The model replaces
backward-looking indexation à la Christiano et al. [2005. Nominal rigidities
and the dynamic effect of a shock to monetary policy. Journal of Political Economy
113(1), 1–45] with a dynamic externality into the production function of firms.
The model, armed with sticky wages and variable capital utilization, has two offsetting
effects on real marginal cost over the business cycle. First, increasing factor prices
raise real marginal cost in response to an expansionary monetary policy shock in
the intermediate run. Second, a dynamic externality reduces real marginal cost in
the short run because it raises productivity in response to an increase in output
following the shock. Overall, the resulting short-run decrease and intermediate-run
increase in marginal cost replicate the hump-shaped behavior of inflation under purely
forward-looking price and wage Phillips curves.
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