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The Asymmetric Outcome of Sticky Price Models

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  • Carles Ibanez
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    Abstract

    Empirical evidence shows demand shocks tend to have an asymmetric effect on output: it falls by a larger amount with a contraction than it rises with an expansion. We argue that introducing nominal rigidities in a framework where agents maximise their welfare can yield such an asymmetric outcome. We show that this is the case in the Sticky Prices framework, where each period an exogenously set fraction of firms fails to adjust prices. While the solution method commonly adopted by this literature, the log-linearization, delivers a perfectly symmetric response, methods that respect the original struc- ture of the model yield an asymmetric one. We show that when products are good substitutes to each other and labour supply is inelastic, the model implies that the response of output is larger with monetary contractions than with ex- pansions, even when the shock is small. We identify the origin of the asymmetry in that when not all firms adjust prices, some goods are cheaper than others and so more heavily consumed. With a positive shock, these goods are produced by the firms that fail to adjust, so that real income is not very much affected. But with a negative shock, they are produced by firms that adjust prices, causing a large swing in real income.

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    Bibliographic Info

    Paper provided by Department of Economics, University of York in its series Discussion Papers with number 07/19.

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    Date of creation: Jun 2007
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    Handle: RePEc:yor:yorken:07/19

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    Keywords: staggered price setting; asymmetric response to shocks; monetary business cycles;

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    1. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 1996. "Sticky Price Models of the Business Cycle: Can the Contract Multiplier Solve the Persistence Problem?," NBER Working Papers 5809, National Bureau of Economic Research, Inc.
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