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Logit price dynamics

Author

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  • James Costain

    (Banco de España)

  • Anton Nakov

    (Banco de España)

Abstract

We propose a near-rational model of retail price adjustment consistent with microeconomic and macroeconomic evidence on price dynamics. Our framework is based on the idea that avoiding errors in decision making is costly. Given our assumed cost function for error avoidance, the timing of firms’ price adjustments is determined by a weighted binary logit, and the prices they choose are determined by a multinomial logit. We build this behavior into a DSGE model, estimate the decision cost function by matching microdata, and simulate aggregate dynamics using a tractable algorithm for heterogeneous-agent models. Both errors in the prices firms set, and errors in the timing of these adjustments, are relevant for our results. Errors of the first type help make our model consistent with some puzzling observations from microdata, such as the coexistence of large and small price changes, the behavior of adjustment hazards, and the relative variability of prices and costs. Errors of the second type increase the real effects of monetary shocks, by reducing the correlation between the value of price adjustment and the probability of adjustment, (i.e., by reducing the\selection effect»). Allowing for both types of errors also helps reproduce the effects of trend inflation on price adjustment behavior. Our model of error-prone pricing in many ways resembles a stochastic menu cost (SMC) model, but it has less free parameters than most SMC models have, and unlike those models, it does not require the implausible assumption of i.i.d. adjustment costs. Our derivation of a weighted logit from control costs oers an alternative justication for the adjustment hazard derived by Woodford (2008). Our assumption that costs are related to entropy is similar to the framework of Sims (2003) and the subsequent\rational inattention» literature. However, our setup has the major technical advantage that a firm’s idiosyncratic state variable is simply its price level and productivity, whereas under rational inattention a firm’s idiosyncratic state is its prior (which is generally an infinite-dimensional object).

Suggested Citation

  • James Costain & Anton Nakov, 2013. "Logit price dynamics," Working Papers 1301, Banco de España.
  • Handle: RePEc:bde:wpaper:1301
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    Cited by:

    1. Costain, James & Nakov, Anton, 2015. "Precautionary price stickiness," Journal of Economic Dynamics and Control, Elsevier, vol. 58(C), pages 218-234.
    2. David R. Munro, 2021. "Consumer Behavior and Firm Volatility," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 53(4), pages 845-873, June.
    3. Khaw, Mel Win & Stevens, Luminita & Woodford, Michael, 2017. "Discrete adjustment to a changing environment: Experimental evidence," Journal of Monetary Economics, Elsevier, vol. 91(C), pages 88-103.
    4. Costain, James & Nakov, Anton & Petit, Borja, 2018. "Monetary policy implications of state-dependent prices and wages," CEPR Discussion Papers 13398, C.E.P.R. Discussion Papers.
    5. Russell W. Cooper & Immo Schott, 2013. "Capital Reallocation and the Cyclicality of Aggregate Productivity," NBER Working Papers 19715, National Bureau of Economic Research, Inc.
    6. Guido Ascari & Timo Haber, 2019. "Sticky prices and the transmission mechanism of monetary policy: A minimal test of New Keynesian models," Economics Series Working Papers 869, University of Oxford, Department of Economics.
    7. Shaowen Luo & Daniel Villar, 2021. "The Skewness of the Price Change Distribution: A New Touchstone for Sticky Price Models," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 53(1), pages 41-72, February.
    8. Mauersberger, Felix, 2019. "Thompson Sampling: Endogenously Random Behavior in Games and Markets," VfS Annual Conference 2019 (Leipzig): 30 Years after the Fall of the Berlin Wall - Democracy and Market Economy 203600, Verein für Socialpolitik / German Economic Association.
    9. James Costain, 2017. "Costly decisions and sequential bargaining," Working Papers 1729, Banco de España.
    10. Cristina Conflitti & Riemer P. Faber & Brian Fabo & Ludmila Fadejeva & Erwan Gautier & Valentin Jouvanceau & Jan-Oliver Menz & Teresa Messner & Pavlos Petroulas & Pau Roldan-Blanco & Fabio Rumler & Se, 2022. "New Facts on Consumer Price Rigidity in the Euro Area (Erwan Gautier, Cristina Conflitti, Riemer P. Faber, Brian Fabo, Ludmila Fadejeva, Valentin Jouvanceau, Jan-Oliver Menz, Teresa Messner, Pavlos Pe," Working Papers 240, Oesterreichische Nationalbank (Austrian Central Bank).

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    More about this item

    Keywords

    nominal rigidity; logit equilibrium; state-dependent pricing; near rationality; information-constrained pricing;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games

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