Department of Economics Working Papers,
Vienna University of Economics and Business, Department of Economics

Abstract: Motivated by recent empirical findings that emphasize low-frequency movements in inflation as a key determinant of term structure, we introduce trend inflation into the workhorse macro-finance model. We show that this compromises the earlier model success and delivers implausible business cycle and bond price dynamics. We document that this result applies more generally to non-linearly solved models with Calvo pricing and trend inflation and is driven by the behavior of price dispersion, which is i) counterfactually high and ii) highly inaccurately approximated. We highlight the channels behind the undesired performance under trend inflation and propose several remedies.

Keywords: trend inflation, Calvo pricing, price dispersion, macro-finance, non-linear solution methods

JEL-codes: E13; E31; E43; E44 October 2020

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