Endogenous Markups in the New Keynesian Model: Implications for Inflation-Output Trade-Off and Welfare

The standard new Keynesian model is unable to generate the inflation-output trade-off that Central Banks face in the real world, unless fluctuations are driven by shocks to desired price or wage markups. In this paper, I explore whether or not a model with endogenous markups can generate such a trade-off in response to more conventional shocks. In this model, the elasticity of product demand, and therefore the price markups, depends on the market share of a firm. I first prove that the change in markup, when combined with the effect of the shock creating this change, does not lead to the trade-off I seek. Then I analyze welfare implications and optimal policy, and show that because the flexible price markup is not affected, it is still optimal to target the flexible price equilibrium.