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Optimal Price and Inventory Adjustment in an Open-Economy Model of the Business Cycle

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  • Robert P. Flood
  • Robert J. Hodrick

Abstract

This paper develops an open-economy macroeconomic model which can be used to interpret the observed fluctuations in output, inventories,prices,and exchange rates in the medium-sized economies of the world. The model is consistent with the major empirical regularities that have been discovered in studies of business cycles as closed-economy phenomena and in empirical studies of prices and exchange rates. The empirical regularities are (i) changes in the nominal money supply cause real output fluctuations, (ii) deviations of output from a "natural rate" show persistence, (iii)exchangerates are more volatile than nominal prices of goods, and (iv) depreciations of the currency coincide with deteriorations of the terms of trade. A controversial aspect of the model is that only unperceived money has real effects. The channel through which these effects arise involves a misperception by rational maximizing firms of the true demand that they will face after having set prices. The firms learn about their environment from equilibrium asset prices, and the dynamics of the model reflect the optimal response of inventory-holding firms rather than ad hoc price dynamics.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1089.

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Date of creation: Mar 1986
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Handle: RePEc:nbr:nberwo:1089

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References

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  1. Sargent, Thomas J, 1976. "A Classical Macroeconometric Model for the United States," Journal of Political Economy, University of Chicago Press, vol. 84(2), pages 207-37, April.
  2. Frenkel, Jacob A & Mussa, Michael L, 1980. "The Efficiency of Foreign Exchange Markets and Measures of Turbulence," American Economic Review, American Economic Association, vol. 70(2), pages 374-81, May.
  3. Frederic S. Mishkin, 1982. "Does Anticipated Monetary Policy Matter? An Econometric Investigation," NBER Working Papers 0506, National Bureau of Economic Research, Inc.
  4. Robert J. Barro & Mark Rush, 1980. "Unanticipated Money and Economic Activity," NBER Chapters, in: Rational Expectations and Economic Policy, pages 23-73 National Bureau of Economic Research, Inc.
  5. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
  6. Makin, John H, 1982. "Anticipated Money, Inflation Uncertainty and Real Economic Activity," The Review of Economics and Statistics, MIT Press, vol. 64(1), pages 126-34, February.
  7. Martin Feldstein & Alan Auerbach, 1976. "Inventory Behavior in Durable-Goods Manufacturing: The Target-Adjustment Model," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 7(2), pages 351-408.
  8. Gray, Jo Anna, 1976. "Wage indexation: A macroeconomic approach," Journal of Monetary Economics, Elsevier, vol. 2(2), pages 221-235, April.
  9. Alan S. Blinder, 1983. "Inventories and Sticky Prices: More on the Microfoundations of Macroeconomics," NBER Working Papers 0620, National Bureau of Economic Research, Inc.
  10. Matthew B. Canzoneri & Dale W. Henderson & Kenneth S. Rogoff, 1981. "The information content of the interest rate and optimal monetary policy," International Finance Discussion Papers 192, Board of Governors of the Federal Reserve System (U.S.).
  11. Ray C. Fair, 1978. "An Analysis of the Accuracy of Four Macroeconometric Models," Cowles Foundation Discussion Papers 492, Cowles Foundation for Research in Economics, Yale University.
  12. John H. Makin, 1982. "Anticipated Money, Inflation Uncertainty, and Real Economic Activity," NBER Working Papers 0760, National Bureau of Economic Research, Inc.
  13. Amihud, Yakov & Mendelson, Haim, 1982. "The output-inflation relationship : An inventory-adjustment approach," Journal of Monetary Economics, Elsevier, vol. 9(2), pages 163-184.
  14. Michael C. Lovell, 1959. "Manufacturers' Inventories, Sales Expectations, and the Acceleration Principle," Cowles Foundation Discussion Papers 86, Cowles Foundation for Research in Economics, Yale University.
  15. Eichenbaum, Martin, 1983. "A rational expectations equilibrium model of inventories of finished goods and employment," Journal of Monetary Economics, Elsevier, vol. 12(2), pages 259-277.
  16. Bennett T. McCallum, 1982. "Macroeconomics after a decade of rational expectations : some critical issues," Economic Review, Federal Reserve Bank of Richmond, issue Nov, pages 3-12.
  17. Mussa, Michael, 1979. "Empirical regularities in the behavior of exchange rates and theories of the foreign exchange market," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 11(1), pages 9-57, January.
  18. King, Robert G, 1982. "Monetary Policy and the Information Content of Prices," Journal of Political Economy, University of Chicago Press, vol. 90(2), pages 247-79, April.
  19. Kohn, Meir, 1981. "In Defense of the Finance Constraint," Economic Inquiry, Western Economic Association International, vol. 19(2), pages 177-95, April.
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Citations

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Cited by:
  1. Robert P. Flood & Robert J. Hodrick, 1986. "Money and the Open Economy Business Cycle: A Flexible Price Model," NBER Working Papers 1967, National Bureau of Economic Research, Inc.
  2. Michael T. Kiley, 1996. "The lead of output over inflation in sticky price models," Finance and Economics Discussion Series 96-33, Board of Governors of the Federal Reserve System (U.S.).
  3. Aizenman, Joshua, 1989. "Monopolistic competition, relative prices, and output adjustment in the open economy," Journal of International Money and Finance, Elsevier, vol. 8(1), pages 5-28, March.
  4. Maurice Obstfeld & Alan C. Stockman, 1985. "Exchange-Rate Dynamics," NBER Working Papers 1230, National Bureau of Economic Research, Inc.
  5. McCallum, Bennett T., 1994. "A semi-classical model of price-level adjustment," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 41(1), pages 251-284, December.
  6. Joshua Aizenman, 1990. "Market Power and Exchange Rate Adjustment in the Presence of Quotas," NBER Working Papers 2370, National Bureau of Economic Research, Inc.
  7. repec:ebl:ecbull:v:5:y:2002:i:5:p:1-7 is not listed on IDEAS
  8. Joshua Aizenman, 1985. "Monopolistic Competition and Deviations from PPP," NBER Working Papers 1552, National Bureau of Economic Research, Inc.

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