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The frequency of price adjustment and New Keynesian business cycle dynamics

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  • Richard Dennis

Abstract

The Calvo pricing model that lies at the heart of many New Keynesian business cycle models has been roundly criticized for being inconsistent both with time series data on inflation and with micro-data on the frequency of price changes. In this paper we show that a modified version of the Gali and Gertler (1999) model, which allows for "rule-of-thumb" price setters, and whose structure can be interpreted in terms of menu costs and information gathering/processing costs, largely resolves both criticisms. Moreover, the resulting Phillips curve shares the explanatory power of the partial-indexation model and dominates the full-indexation model and the Calvo model. Estimating a small-scale New Keynesian business cycle model, our results indicate that the share of firms that change prices each quarter is just over 60 percent, broadly in line with the Bils and Klenow (2004) study of Bureau of Labor Statistics price data. Reflecting the importance of information gathering/processing costs, we find that most firms that change prices are rule-of-thumb price setters. Finally, compared to specifications containing either the Calvo model or the full-indexation model, the data provide much greater support for the Gali-Gertler model.

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Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2006-22.

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Date of creation: 2006
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Handle: RePEc:fip:fedfwp:2006-22

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Keywords: Prices ; Inflation (Finance);

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Cited by:
  1. Helmut Hofer & Torsten Schmidt & Klaus Weyerstrass, 2010. "Practice and prospects of medium-term economic forecasting," NRN working papers 2010-12, The Austrian Center for Labor Economics and the Analysis of the Welfare State, Johannes Kepler University Linz, Austria.
  2. Daniel Kaufmann, 2010. "The Timing of Price Changes and the Role of Heterogeneity," Working Papers 2010-02, Swiss National Bank.
  3. Adam Cagliarini & Tim Robinson & Allen Tran, 2010. "Reconciling Microeconomic and Macroeconomic Estimates of Price Stickiness," RBA Research Discussion Papers rdp2010-01, Reserve Bank of Australia.
  4. Richard Dennis, 2007. "Fixing the New Keynesian Phillips curve," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue nov30.

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