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A “Local” Model of the Firm: Sticky prices and the Phillips Curve

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  • Daley, Clayton

Abstract

Assume a firm concerns itself exclusively with local shocks (copious citations including Lucas 1972 and Bomhoff 1983 validate that this type of assumption may be reasonable). Changes in a firm's production policy should occur when the actual demand in a period Dt suggests that the underlying demand function has shifted from expected demand E(Dt). Since firms face uncertainty, this is non-trivial and they must find a way to determining (given information from a single, current period) whether or not the underlying demand has changed or whether the firm has simply obtained a draw from its expected demand distribution. In a simplified model, a firm can use a concept similar to a Statistical Hypothesis Test on E(Dt) = Dt to come to this conclusion. Rather than select an arbitrary confidence threshold (alpha), a firm can reverse the process and use the "marginal" alpha (where the hypothesis is just rejected or accepted) as its confidence that the mean has changed, allowing it to update its expectations to E(Dt+1) = (1-a) * E(Dt) + a * (Dt) and price accordingly. By weighting new demand information using this "confidence factor," the model introduces significant and persistent rigidity around NAIRU/equilibrium. This model is also powerful because it explains the qualified success of threshold like behaivor in classical "menu cost" theories (as the threshold reflects the classic hypothesis test strategy), behavior similar to a learning model (via the weighted introduction of new data) and seeming information lags (via the low confidence in new information immediately after shifts), among others.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 4012.

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Date of creation: 11 Jul 2007
Date of revision: 11 Jul 2007
Handle: RePEc:pra:mprapa:4012

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Keywords: phillips curve;

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  1. Mankiw, N. Gregory & Reis, Ricardo, 2002. "Sticky Information Versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve," Scholarly Articles 3415324, Harvard University Department of Economics.
  2. Allan H. Meltzer, 1995. "Information, sticky prices and macroeconomic foundations," Proceedings, Federal Reserve Bank of St. Louis, issue May, pages 101-118.
  3. N. Gregory Mankiw & Ricardo Reis, 2006. "Pervasive Stickiness," American Economic Review, American Economic Association, vol. 96(2), pages 164-169, May.
  4. Robert J. Gordon, 1981. "Output Fluctuations and Gradual Price Adjustment," NBER Working Papers 0621, National Bureau of Economic Research, Inc.
  5. Barro, Robert J, 1972. "A Theory of Monopolistic Price Adjustment," Review of Economic Studies, Wiley Blackwell, vol. 39(1), pages 17-26, January.
  6. Laurence Ball & David Romer, 1987. "The Equilibrium and Optimal Timing of Price Changes," NBER Working Papers 2432, National Bureau of Economic Research, Inc.
  7. Brunner, Karl & Cukierman, Alex & Meltzer, Allan H., 1983. "Money and economic activity, inventories and business cycles," Journal of Monetary Economics, Elsevier, vol. 11(3), pages 281-319.
  8. Olivier Coibion, 2007. "Testing the Sticky Information Phillips Curve," Working Papers 61, Department of Economics, College of William and Mary.
  9. Sims, Christopher A., 2003. "Implications of rational inattention," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 665-690, April.
  10. Barro, Robert J., 1976. "Rational expectations and the role of monetary policy," Journal of Monetary Economics, Elsevier, vol. 2(1), pages 1-32, January.
  11. Carlton, Dennis W, 1986. "The Rigidity of Prices," American Economic Review, American Economic Association, vol. 76(4), pages 637-58, September.
  12. Blinder, Alan S, 1991. "Why Are Prices Sticky? Preliminary Results from an Interview Study," American Economic Review, American Economic Association, vol. 81(2), pages 89-96, May.
  13. Klenow, Peter J. & Willis, Jonathan L., 2007. "Sticky information and sticky prices," Journal of Monetary Economics, Elsevier, vol. 54(Supplemen), pages 79-99, September.
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