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Menu Costs, Uncertainty Cycles, and the Propagation of Nominal Shocks

Listed author(s):
  • Isaac Baley
  • Julio A. Blanco

Nominal shocks have long-lasting effects on real economic activity, beyond those implied by standard models that target the average frequency of price adjustment in micro data. This paper develops a price-setting model that explains this gap through the interplay of menu costs and uncertainty about idiosyncratic productivity. Uncertainty arises from firms' inability to distinguish between permanent and transitory productivity changes. Upon the arrival of a productivity shock, a firm's uncertainty spikes up and then fades with learning until the next shock arrives. These uncertainty cycles, when paired with menu costs, generate recurrent episodes of high adjustment frequency followed by episodes of low adjustment frequency at the firm level. A decreasing hazard rate of price adjustment results, as in the data. Taking into account this pricing behavior amplifies the persistence and reduces the pass-through of nominal shocks.

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Paper provided by Barcelona Graduate School of Economics in its series Working Papers with number 918.

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Date of creation: Jul 2016
Handle: RePEc:bge:wpaper:918
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