What really drives inflation?

Abstract

We derive a broad measure of real marginal cost which features the labour share, output gap and supply shock variables. We evaluate the contribution of each of these components of real marginal cost as driving forces for inflation. We find that supply shock variables dominate the output gap and the labour share in driving inflation dynamics. This finding suggests that a more elaborate real marginal cost function should be considered by the new Keynesian literature. Tests of the new Keynesian Phillips curve that are based on the restrictive one-factor production technology should therefore be reconsidered. In the light of this, forecast-based policy rules require more serious study, since they permit more flexibility to respond to supply shocks without generating significant output loss.

Keywords:

• Phillips curve
• supply shocks
• marginal cost

JEL Classification:

• E31