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Implications of state-dependent pricing for dynamic macroeconomic models

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Michael Dotsey
Robert G. King

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Abstract

State-dependent pricing (SDP) models treat the timing of price changes as a profit-maximizing choice, symmetrically with other decisions of firms. Using quantitative general equilibrium models that incorporate a “generalized (S,s) approach,” we investigate the implications of SDP for topics in two major areas of macroeconomic research: the early 1990s SDP literature and more recent work on persistence mechanisms. First, we show that state-dependent pricing leads to unusual macroeconomic dynamics, which occur because of the timing of price adjustments chosen by firms as in the earlier literature. In particular, we display an example in which output responses peak at about a year, while inflation responses peak at about two years after the shock. Second, we examine whether the persistence-enhancing effects of two New Keynesian model features, namely, specific factor markets and variable elasticity demand curves, depend importantly on whether pricing is state dependent. In an SDP setting, we provide examples in which specific factor markets perversely work to lower persistence, while variable elasticity demand raises it.

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Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 05-2.

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Date of creation: 2005
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Handle: RePEc:fip:fedpwp:05-2

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Keywords: Price levels

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