Trend Inflation and an Empirical Test of Real Rigidities

Positive trend inflation resolves the observational equivalence of various sources of real rigidities which are first-order equivalent under zero trend inflation. This paper builds on this observation to assess the empirical performance of three widely used types of real rigidities — firm-specific capital, firm-specific wages and a kinked-demand curve — in matching the U.S. inflation dynamics. Firm-specific wages outperform the kinked-demand curve and firm-specific capital in terms of empirical fit. We document that positive trend inflation might reduce the ability of firm-specific factors to prolong the real affects of monetary disturbances