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Adjustment Is Much Slower Than You Think

Author

Listed:
  • Ricardo J. Caballero
  • Eduardo M.R.A. Engel

    () (Dept. of Economics, Yale University)

Abstract

In most instances, the dynamic response of monetary and other policies to shocks is infrequent and lumpy. The same holds for the microeconomic response of some of the most important economic variables, such as investment, labor demand, and prices. We show that the standard practice of estimating the speed of adjustment of such variables with partial-adjustment ARMA procedures substantially overestimates this speed. For example, for the target federal funds rate, we find that the actual response to shocks is less than half as fast as the estimated response. For investment, labor demand and prices, the speed of adjustment inferred from aggregates of a small number of agents is likely to be close to instantaneous. While aggregating across microeconomic units reduces the bias (the limit of which is illustrated by Rotemberg's widely used linear aggregate characterization of Calvo's model of sticky prices), in some instances convergence is extremely slow. For example, even after aggregating investment across all establishments in U.S. manufacturing, the estimate of its speed of adjustment to shocks is biased upward by more than 80 percent. While the bias is not as extreme for labor demand and prices, it still remains significant at high levels of aggregation. Because the bias rises with disaggregation, findings of microeconomic adjustment that is substantially faster than aggregate adjustment are generally suspect.

Suggested Citation

  • Ricardo J. Caballero & Eduardo M.R.A. Engel, 2003. "Adjustment Is Much Slower Than You Think," Working Papers 865, Economic Growth Center, Yale University.
  • Handle: RePEc:egc:wpaper:865
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    File URL: http://www.econ.yale.edu/growth_pdf/cdp865.pdf
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    References listed on IDEAS

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    1. Mark Bils & Peter J. Klenow, 2004. "Some Evidence on the Importance of Sticky Prices," Journal of Political Economy, University of Chicago Press, vol. 112(5), pages 947-985, October.
    2. Caballero, Ricardo J., 1999. "Aggregate investment," Handbook of Macroeconomics,in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 12, pages 813-862 Elsevier.
    3. Majd, Saman & Pindyck, Robert S., 1987. "Time to build, option value, and investment decisions," Journal of Financial Economics, Elsevier, vol. 18(1), pages 7-27, March.
    4. Goodfriend, Marvin, 1987. "Interest rate smoothing and price level trend-stationarity," Journal of Monetary Economics, Elsevier, pages 335-348.
    5. Sargent, Thomas J, 1978. "Estimation of Dynamic Labor Demand Schedules under Rational Expectations," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 1009-1044, December.
    6. Ricardo J. Caballero & Eduardo M. R. A. Engel & John C. Haltiwanger, 1995. "Plant-Level Adjustment and Aggregate Investment Dynamics," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, pages 1-54.
    7. Michael Woodford, 1999. "Optimal monetary policy inertia," Proceedings, Federal Reserve Bank of San Francisco.
    8. Marvin Goodfriend, 1987. "Interest rate smoothing and price level trend-stationarity," Working Paper 87-03, Federal Reserve Bank of Richmond.
    9. Brian P. Sack, 1998. "Uncertainty, learning, and gradual monetary policy," Finance and Economics Discussion Series 1998-34, Board of Governors of the Federal Reserve System (U.S.).
    10. Caballero, Ricardo J & Engel, Eduardo M R A & Haltiwanger, John, 1997. "Aggregate Employment Dynamics: Building from Microeconomic Evidence," American Economic Review, American Economic Association, pages 115-137.
    11. Julio Rotemberg, 1987. "The New Keynesian Microfoundations," NBER Chapters,in: NBER Macroeconomics Annual 1987, Volume 2, pages 69-116 National Bureau of Economic Research, Inc.
    12. Bennett T. McCallum & Marvin S. Goodfriend, 1988. "Theoretical analysis of the demand of money," Economic Review, Federal Reserve Bank of Richmond, pages 16-24.
    13. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, pages 383-398.
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    Citations

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    Cited by:

    1. Caggiano, Giovanni & Castelnuovo, Efrem, 2011. "On the dynamics of international inflation," Economics Letters, Elsevier, vol. 112(2), pages 189-191, August.
    2. Patrick Lünnemann & Thomas Y. Mathä, 2010. "Rigidities and inflation persistence of services and regulated prices," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 31(2-3), pages 193-208.
    3. Denis Fougere & Erwan Gautier & Herve Le Bihan, 2010. "Restaurant Prices and the Minimum Wage," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(7), pages 1199-1234, October.
    4. Jonathan Wadsworth, 2010. "Did the National Minimum Wage Affect UK Prices?," Fiscal Studies, Institute for Fiscal Studies, pages 81-120.
    5. Todd E. Clark, 2006. "Disaggregate evidence on the persistence of consumer price inflation," Journal of Applied Econometrics, John Wiley & Sons, Ltd., pages 563-587.
    6. Albert Marcet & Juan Pablo Nicolini, 2005. "Money and Prices in Models of Bounded Rationality in High Inflation Economies," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, pages 452-479.
    7. Daniele Coen-Pirani, 2004. "Markups, Aggregation, and Inventory Adjustment," American Economic Review, American Economic Association, pages 1328-1353.
    8. Juan Pablo Medina G. & David Rappoport W. & Claudio Soto G., 2007. "Dynamics of Price Adjustments: Evidence From Micro Level Data For Chile," Journal Economía Chilena (The Chilean Economy), Central Bank of Chile, pages 5-26.
    9. Christian Calmès & Raymond Théoret, 2009. "The Impact of Off-Balance-Sheet Activities on Banks Returns: An Application of the ARCH-M to Canadian Data," RePAd Working Paper Series UQO-DSA-wp032009, Département des sciences administratives, UQO.
    10. Firgo, Matthias & Pennerstorfer, Dieter & Weiss, Christoph, 2015. "Network Centrality and Market Prices: An Empirical Note," Department of Economics Working Paper Series 4651, WU Vienna University of Economics and Business.
    11. Filippo Altissimo & Michael Ehrmann & Frank Smets, 2006. "Inflation persistence and price-setting behaviour in the euro area – a summary of the IPN evidence," Occasional Paper Series 46, European Central Bank.
    12. Adams, Zeno & Füss, Roland, 2010. "Macroeconomic determinants of international housing markets," Journal of Housing Economics, Elsevier, vol. 19(1), pages 38-50, March.
    13. Calmès, Christian & Théoret, Raymond, 2010. "The impact of off-balance-sheet activities on banks returns: An application of the ARCH-M to Canadian data," Journal of Banking & Finance, Elsevier, vol. 34(7), pages 1719-1728, July.

    More about this item

    Keywords

    Speed of adjustment; discrete adjustment; lumpy adjustment; aggregation; Calvo model; ARMA process; partial adjustment; expected response time; monetary policy; investment; labor demand; sticky prices; idiosyncratic shocks; impulse response function; Wold representation; time-to-build;

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • C43 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Index Numbers and Aggregation
    • D2 - Microeconomics - - Production and Organizations
    • E2 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit

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