We develop a New Keynesian (NK) model with endogenous price setting frequency. Whether a firm updates its price is a discrete choice: when expected benefits outweigh expected costs, prices are reset optimally. The model gives rise to a non-linear Phillips curve as prices are more flexible during demand-driven expansions and less so during demand-driven recessions. Monetary policy can have substantial real effects despite the model having a state-dependent pricing component. Our quantitative analysis shows that contrary to the standard NK model, the assumed price setting behavior: (i) is consistent with micro data on price setting frequency; (ii) generates a direct effect of the time-varying price setting frequency on inflation; (iii) creates time-variation in the Phillips curve slope that explains shifts in the Phillips curve associated with different historical episodes; (iv) explains inflation dynamics without relying on implausible high cost-push shocks and nominal rigidities inconsistent with micro data; (v) reconciles the NK model with observed inflation moments.

The authors thank the editors Evi Pappa and Florin O. Bilbiie, the asscoiate editor, two anonymous referees, Steffen Ahrens, Guido Ascari, Gregor Böhl, Flora Budianto, James Costain, George Evans, Cars Hommes, Alistair Macaulay, Domenico Massaro, Mathias

Price setting,Inflation dynamics,Monetary policy,Phillips curve

• Economics and Business - Social Sciences