Sales and promotions and the great recession deflation

This paper investigates the effect of sales and promotions on the pricing decisions of firms by providing a novel theoretical model where firms face price adjustment costs and offer items on sale to attract bargain hunters. It is demonstrated that in a recession, the frequency of items on sale increases as well as the effort of consumers to locate such offers. Since the decrease in the cost of living following a recession comes both from price decreases and the combination of more frequent sales and more active bargain hunting by consumers, a price index that simply focuses on prices and neglects high-frequency sales and their weight in the consumer’s basket appears to be less responsive to shocks. This can explain the low response of inflation in the post-crisis period and thus the breakdown of the Phillips curve as sales items is under-represented in common price indexes. This study also shows that a price index created by placing more weight on sale items in the UK CPI correlates better with the output gap, confirming the model’s predictions. Additionally, if agents form inflation expectations using indices that neglect sales and promotions, recessions are exacerbated.