State Dependent Pricing and Business Cycle Asymmetries

We present a tractable model of state-dependent pricing and study the incentive for firms to adjust their price in response to shocks. We find a distinct asymmetry in this response. Positive shocks generate greater price flexibility (and smaller output effects) than negative shocks of the same magnitude. This asymmetry arises due to a strategic linkage between firms in the incentive to adjust prices. With a positive marginal cost shock, prices are strategic complements: firms have more incentive to increase their price when other firms increase theirs. But for a negative shock, prices are strategic substitutes: firms have less incentive to lower prices when other firms lower theirs. We analyze this asymmetry in the context of a simple dynamic macro model, and examine the response of aggregate prices and quantities to monetary policy shocks. We stress two results of this exercise. First, for empirically relevant shocks there is a substantial difference between state-dependent and time-dependent pricing. Second, our state-dependent pricing model can account for business cycle asymmetries of the magnitude that have been found empirically