Firm entry and exit and the cost of disinflations

The log-linearized version of the basic New Keynesian model with real wage

rigidity generates a recession in response to a credible and permanent disinflation by the central bank. However, its nonlinear version implies that permanent disinflation actually leads to a boom (except when the initial steady state inflation rate is close to zero), and under real wage rigidity output increases during the adjustment to the new steady state. This paper shows

that the presence of firm entry and exit may help reconcile the log-linear and

non-linear properties of the model with respect to the output cost of disinflations. In this regard, the degree of price flexibility of incumbents versus new

entrants plays a role in determining the transitional dynamics following the

disinflation policy.