2  2  All speeches are available online at www.bankofengland.co.uk/speeches  2  To explore these issues, we start by discussing briefly recent empirical evidence on market power and its potential macro-economic explanations and implications. We then explore its effects on monetary policy, using counter-factual policy simulations and adaptations of a simple New Keynesian model. Taken together, this evidence suggests that an increase in market power and mark-ups could have potentially important consequences for the economy and policy. These are summarised, in stylised terms, in Figure 1. To the extent a secular rise in mark-ups reflects a set of trade-off inducing shocks, that would shift outwards the output/inflation variability (policy possibility) frontier (from A to B). It may steepen the Phillips curve, causing the policy possibility frontier to rotate clockwise (B to C). And it may also potentially alter the optimal weights placed on output and inflation stabilisation by the policymaker, shifting the point of tangency between the policy possibility frontier and policymakers’ loss function (C to D). Taken together, the net effect of increased market power could be a potentially significant rise in inflation (but less so output) variability, relative to the counterfactual case of stable and static mark-ups (A to D). As for monetary policy, the fact that these are trade-off inducing shock places limits on its stabilisation capacity. The (level and variability) of the optimal interest rate path is, as a result, less affected by increased market power, despite significant shifts in policy possibility frontiers and policymaker preferences.
This is a significant change in the parameterisation of a key macro-economic relationship for the setting of monetary policy. One way of explaining the intuition behind this steepening of the Phillips Curve is that market power reduces the degree of strategic complementarity in price-setting. In a product market closer to perfect competition, firms will be reluctant to raise prices fearful that, with other prices in the economy sticky, demand would fallaway sharply. By reducing the elasticity of demand, market power reduces this risk and thus gives rise to greater flexibility in prices – and hence a lower sacrifice ratio (for example, Ball and Romer (1990)). Let us now put this model into a stochastic setting, by assuming desired mark-ups fluctuate around a trend level according to some stationary stochastic process, log 𝜇𝑡 . These would now appear as cost-push disturbances in the Phillips curve:  𝑢𝑡 =  (1 − 𝜃)(1 − 𝛽𝜃) 1 − 𝛼 log 𝜇𝑡 𝜃 1 − 𝛼 + 𝛼𝜖  (7)  This tells us that, when mark-up shocks strike, a greater degree of market power will mean that a larger fraction of the shock will fall on prices than activity. A rise in market power, through its effect on the slope of the Phillips curve, will cause the Taylor output/inflation variability (policy possibility) frontier to rotate clockwise, with more of the burden following a shock felt by inflation than by output variability. 23  De Loecker and Eeckhout (2018).