This dissertation examines the measurement of marginal cost and the implications it has for inflation models. Several authors argue that if the labor income share is used as the proxy for real marginal cost, then the New Keynesian Phillips Curve does a good job of approximating US inflation dynamics. Chapter 2 argues that the labor share is not an ideal proxy for two reasons: it is countercyclical whereas marginal cost is likely to be procyclical, and it assumes that labor can be costlessly adjusted at a fixed real wage rate, which ignores adjustment costs of labor. Relaxing this assumption leads to a new measure of marginal cost that does turn out to be procyclical, which when tested produces results that are contradictory to the entire underlying model of the NKPC. Indeed, having procyclical marginal cost is incompatible with the NKPC, highlighting a major problem that exists in the model.

There are various marginal cost measures that are widely-used in macroeconomics, and Chapter 3 examines which is the most useful as a predictor of future price changes. I use the traditional Phillips Curve to conduct pseudo out-of-sample inflation forecasts for the US using: output, unemployment, the labor share, hours, and the new measure of marginal cost. For almost all cases, forecast errors are lowest in the regressions with this new marginal cost, which is especially pronounced at the manufacturing level. Thus the evidence is that the new measure is an improvement over previous attempts to proxy for marginal cost.

Most existing techniques of estimating the price-marginal cost markup are a variant on Hall's (1988) framework involving the manipulation of the Solow Residual. Chapter 4 argues that this notion is again based on the unreasonable assumption that labor can be costlessly adjusted at a fixed wage. By relaxing this assumption, we are able to derive a generalized markup index, which is highly countercyclical and decreasing in trend since the 1960s for US manufacturing. The most important determinant of this markup behavior is the share of manufactured goods that are imported. Thus, increasing foreign competition in manufacturing has led to a decline in the industry's markup over time.

Keywords: Inflation, Phillips Curve, Marginal Cost, Markup, Inflation Forecasting