Pricing, Production, and Persistence

Though built with increasingly precise microfoundations, modern optimizing sticky price models have displayed a chronic inability to generate large and persistent real responses to monetary shocks, as recently stressed by Chari, Kehoe, and McGrattan (2000). We trace this lack of persistence to a standard view of the cyclical behavior of real marginal cost built into current sticky price macro models. Using a fully articulated general equilibrium model, we develop an alternative perspective on real marginal cost that leads to substantial persistence. Based on an important role for materials input, variable capacity utilization, and labor adjustment on the extensive margin, this alternative view also makes the sticky price model display volatility and comovement of factor inputs and factor prices more closely in line with conventional wisdom about business cycles and various empirical studies of the dynamic effects of monetary shocks.(JEL: E31 E32) (c) 2006 by the European Economic Association.