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Price setting and the steady-state effects of inflation

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  • Casares, Miguel

Abstract

This paper examines how price setting plays a key role in explaining the steady-state effects of inflation in a monopolistic competition economy. Three pricing variants (optimal prices, indexed prices, and unchanged prices) are introduced through a generalization of the Calvo-type setting that allows the possibility of price indexation, i.e., prices may be adjusted by the rate of inflation. We found that in an economy with less indexed prices the steady-state negative impact of inflation on output is higher. In the extreme case without no price indexation at all (purely Calvo-type economy), unrealistically heavy falls in capital and output were reported when steady-state inflation increases. Regarding welfare analysis, our results support a long-run monetary policy aimed at price stability with a close-to-zero inflation target. This finding is robust to any price setting scenario. JEL Classification: E13, E31, E50

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Bibliographic Info

Paper provided by European Central Bank in its series Working Paper Series with number 0140.

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Date of creation: May 2002
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Handle: RePEc:ecb:ecbwps:20020140

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Keywords: price setting; superneutrality; welfare cost of inflation;

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References

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  1. Robert G. King & Alexander L. Wolman, 1996. "Inflation targeting in a St. Louis model of the 21st century," Review, Federal Reserve Bank of St. Louis, issue May, pages 83-107.
  2. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  3. Pencavel, John, 1987. "Labor supply of men: A survey," Handbook of Labor Economics, in: O. Ashenfelter & R. Layard (ed.), Handbook of Labor Economics, edition 1, volume 1, chapter 1, pages 3-102 Elsevier.
  4. Michael Dotsey & Peter Ireland, 1994. "The welfare cost of inflation in general equilibrium," Working Paper 94-04, Federal Reserve Bank of Richmond.
  5. Christopher J. Erceg & Dale W. Henderson & Andrew T. Levin, 1999. "Optimal monetary policy with staggered wage and price contracts," International Finance Discussion Papers 640, Board of Governors of the Federal Reserve System (U.S.).
  6. Jag Chadha & Andrew Haldane & Norbert Janssen, 1998. "Shoe-leather costs reconsidered," Bank of England working papers 86, Bank of England.
  7. Dixit, Avinash K & Stiglitz, Joseph E, 1977. "Monopolistic Competition and Optimum Product Diversity," American Economic Review, American Economic Association, vol. 67(3), pages 297-308, June.
  8. Robert King & Alexander L. Wolman, 1999. "What Should the Monetary Authority Do When Prices Are Sticky?," NBER Chapters, in: Monetary Policy Rules, pages 349-404 National Bureau of Economic Research, Inc.
  9. Alexander L. Wolman, 1997. "Zero inflation and the Friedman rule: a welfare comparison," Economic Quarterly, Federal Reserve Bank of Richmond, issue Fall, pages 1-21.
  10. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
  11. Michael Dotsey & Robert G. King & Alexander L. Wolman, 1999. "State-Dependent Pricing And The General Equilibrium Dynamics Of Money And Output," The Quarterly Journal of Economics, MIT Press, vol. 114(2), pages 655-690, May.
  12. Miguel Casares, 2001. "Long-Run Analysis in Alternative Optimizing Monetary Models," Documentos de Trabajo - Lan Gaiak Departamento de Economía - Universidad Pública de Navarra 0107, Departamento de Economía - Universidad Pública de Navarra.
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Cited by:
  1. Levin, Andrew & Yun, Tack, 2007. "Reconsidering the natural rate hypothesis in a New Keynesian framework," Journal of Monetary Economics, Elsevier, vol. 54(5), pages 1344-1365, July.
  2. Matthews, Kent & Meenagh, David & Minford, Patrick & Webb, Bruce, 2006. "Monetary regimes: is there a trade-off between consumption and employment variability?," Cardiff Economics Working Papers E2006/12, Cardiff University, Cardiff Business School, Economics Section.
  3. Miguel Casares, 2007. "Monopolistic Competition, Sticky Prices, and the Minimal Mark-Up in Steady State," Documentos de Trabajo - Lan Gaiak Departamento de Economía - Universidad Pública de Navarra 0702, Departamento de Economía - Universidad Pública de Navarra.
  4. Le, Vo Phuong Mai & Minford, Patrick, 2007. "Optimising indexation arrangements under Calvo contracts and their implications for monetary policy," Cardiff Economics Working Papers E2007/7, Cardiff University, Cardiff Business School, Economics Section.
  5. Minford, Patrick & Peel, David, 2004. "Calvo Contracts: A Critique," CEPR Discussion Papers 4288, C.E.P.R. Discussion Papers.

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