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A Kinked-Demand Theory of Price Rigidity

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  • S. Dupraz

Abstract

I provide a microfounded theory for one of the oldest, but so far informal, explanations of price rigidity: the kinked demand curve theory. Assuming that some customers observe at no cost only the price of the store they happen to be at gives rise to a kink in firms' demand curves: a price increase above the market price repels more customers than a price decrease attracts. The kink in turn makes a range of prices consistent with equilibrium, but a selection criterion that captures firms' reluctance to be the first to change prices---the adaptive rational-expectations criterion---selects a unique equilibrium where prices stay constant for a long time. The kinked-demand theory is consistent with price-setters' account of price rigidity as arising from the customer's---not the firm's---side, and their account of their reluctance to make the first step in changing prices. The kinked-demand theory can be tested against menu-cost models in micro data: it predicts that prices should be more likely to change if they have recently changed, and that prices should be more flexible in markets where customers can more easily compare prices. At the macro level, the kinked-demand theory induces a trade-off between output and inflation that substantially differs from prominent theories of sticky prices: the Phillips curve is strongly convex but does not contain any (present or past) expectations of inflation, and is non-vertical in the long-run.

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  • S. Dupraz, 2017. "A Kinked-Demand Theory of Price Rigidity," Working papers 656, Banque de France.
  • Handle: RePEc:bfr:banfra:656
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    Cited by:

    1. Tsutomu Watanabe, 2020. "The Welfare Implications of Massive Money Injection: The Japanese Experience from 2013 to 2020," Working Papers on Central Bank Communication 028, University of Tokyo, Graduate School of Economics.
    2. Cynthia L. Doniger & J. David López-Salido, 2017. "Hysteresis via Endogenous Rigidity in Wages and Participation," Finance and Economics Discussion Series 2017-044, Board of Governors of the Federal Reserve System (U.S.).
    3. Cosmin Ilut & Rosen Valchev & Nicolas Vincent, 2020. "Paralyzed by Fear: Rigid and Discrete Pricing Under Demand Uncertainty," Econometrica, Econometric Society, vol. 88(5), pages 1899-1938, September.
    4. Kosuke Aoki & Hibiki Ichiue & Tatsushi Okuda, 2019. "Consumers' Price Beliefs, Central Bank Communication, and Inflation Dynamics," Bank of Japan Working Paper Series 19-E-14, Bank of Japan.
    5. Lindé, Jesper & Trabandt, Mathias, 2019. "Resolving the Missing Deflation Puzzle," CEPR Discussion Papers 13690, C.E.P.R. Discussion Papers.
    6. Tsutomu Watanabe, 2020. "The Welfare Implications of Massive Money Injection: The Japanese Experience from 2013 to 2020," CARF F-Series CARF-F-493, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo.
    7. Arnildo Correa & Myrian Petrassi & Rafael Santos, 2018. "Price-Setting Behavior in Brazil: Survey Evidence," Journal of Business Cycle Research, Springer;Centre for International Research on Economic Tendency Surveys (CIRET), vol. 14(2), pages 283-310, November.
    8. Pazhanisamy, R., 2018. "Re examination of Kinked Demand Oligopoly Market: Theory, Evidence and Policy Implications from Lakshadweep," MPRA Paper 91176, University Library of Munich, Germany, revised 25 Dec 2018.

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    Keywords

    Kinked demand; Sticky prices; Coordination failures; Phillips curve.;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles

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