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State-dependent pricing and the dynamics of business cycles

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  • Michael Dotsey
  • Robert G. King
  • Alexander L. Wolman

Abstract

The nature of price dynamics has long been thought important for the origin and duration of business cycles. To investigate this topic, we construct a dynamic stochastic general equilibrium macroeconomic model in which monopolistically competitive firms face fixed costs of changing the nominal prices of final goods. These prices are thus changed infrequently and discretely. The framework captures major features of the price dynamics stressed by the New Keynesian research program, particularly work on (s, S) pricing rules. However, by treating firms as heterogenous with respect to the size of fixed costs of price adjustment, we are able to study a wider range of issues than in the prior literature. For example, we explore how the nature of optimal price-setting depends on (i) the extent of persistence of variations in the money stock and (ii) the interest elasticity of money demand. Further, our model can be used to study a wide range of aspects of the positive and normative economics of monetary policy. We illustrate these topics by considering the consequences of changing the rate of inflation and by evaluating alternative policy rules.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Richmond in its series Working Paper with number 97-02.

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Date of creation: 1997
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Handle: RePEc:fip:fedrwp:97-02

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Keywords: Business cycles ; Prices;

References

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  1. Willem H. Buiter & Marcus H. Miller, 1983. "Costs and Benefits of an Anti-Inflationary Policy: Questions and Issues," NBER Working Papers 1252, National Bureau of Economic Research, Inc.
  2. Bernanke, Ben S & Blinder, Alan S, 1992. "The Federal Funds Rate and the Channels of Monetary Transmission," American Economic Review, American Economic Association, vol. 82(4), pages 901-21, September.
  3. Barro, Robert J, 1972. "A Theory of Monopolistic Price Adjustment," Review of Economic Studies, Wiley Blackwell, vol. 39(1), pages 17-26, January.
  4. Blanchard, Olivier Jean & Kiyotaki, Nobuhiro, 1987. "Monopolistic Competition and the Effects of Aggregate Demand," American Economic Review, American Economic Association, vol. 77(4), pages 647-66, September.
  5. Ricardo J. Caballero & Eduardo M.R.A. Engel, 1991. "Dynamic (S,s) Economies," NBER Working Papers 3734, National Bureau of Economic Research, Inc.
  6. Ball, Laurence, 1995. "Disinflation with imperfect credibility," Journal of Monetary Economics, Elsevier, vol. 35(1), pages 5-23, February.
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Citations

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Cited by:
  1. Lorenz Goette & Rudolf Minsch & Jean-Robert Tyran, 2005. "Micro Evidence on the Adjustment of Sticky-Price Goods: It's How Often, not How Much," Discussion Papers 05-20, University of Copenhagen. Department of Economics.
  2. Michael Gail, 2001. "Persistency and Money Demand Distortions in a Stochastic DGE Model with Sticky Prices," Volkswirtschaftliche Diskussionsbeiträge 96-01, Universität Siegen, Fakultät Wirtschaftswissenschaften, Wirtschaftsinformatik und Wirtschaftsrecht, revised 14 Feb 2003.
  3. Alex Ho, Wai-Yip & Yetman, James, 2008. "The long-run output-inflation trade-off with menu costs," The North American Journal of Economics and Finance, Elsevier, vol. 19(3), pages 261-273, December.
  4. Antonio Moreno, 2003. "Reaching Inflation Stability," Faculty Working Papers 13/03, School of Economics and Business Administration, University of Navarra.
  5. 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.
  6. Erceg, Christopher J. & Henderson, Dale W. & Levin, Andrew T., 2000. "Optimal monetary policy with staggered wage and price contracts," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 281-313, October.
  7. Valerie Herzberg & George Kapetanios & Simon Price, 2003. "Import prices and exchange rate pass-through: theory and evidence from the United Kingdom," Bank of England working papers 182, Bank of England.
  8. Michael Gail, 2000. "Optimal Monetary Policy in an Optimizing Stochastic Dynamic Model with Sticky Prices," Volkswirtschaftliche Diskussionsbeiträge 87-00, Universität Siegen, Fakultät Wirtschaftswissenschaften, Wirtschaftsinformatik und Wirtschaftsrecht, revised 15 May 2001.
  9. Michael T. Kiley, 1997. "Staggered price setting and real rigidities," Finance and Economics Discussion Series 1997-46, Board of Governors of the Federal Reserve System (U.S.).
  10. Kolver Hernandez, 2004. "Inflation and Output Dynamics with State-Dependent Frequency of Price Changes," Macroeconomics 0411020, EconWPA.
  11. Michael Gail, 2003. "Habit Persistence in Consumption in a Sticky Price Model of the Business Cycle," Volkswirtschaftliche Diskussionsbeiträge 111-03, Universität Siegen, Fakultät Wirtschaftswissenschaften, Wirtschaftsinformatik und Wirtschaftsrecht, revised Jul 2004.
  12. Katharine S. Neiss & Evi Pappa, 2005. "Persistence without too much price stickiness: the role of variable factor utilization," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 8(1), pages 231-255, January.

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