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Small and Large Price Changes and the Propagation of Monetary Shocks

  • Fernando Alvarez

    (University of Chicago)

  • Hervé Le Bihan

    (Banque de France)

  • Francesco Lippi

    (University of Sassari and EIEF)

We present new evidence on the presence of both small and large price changes in individual price records from the CPI both in France and in the US. After correcting for measurement error and cross-section heterogeneity we find that the size distribution of price changes has a positive excess kurtosis,with a shape that lies between a Normal and a Laplace distribution. We construct a menu-cost model that is capable to reproduce the observed empirical patterns. The model, which features multiproduct firms and randomness in menu cost, has only 4 parameters, two of which are pinned down by the average frequency and by the standard deviation of price changes. Very different propagation mechanism, spanning the models of Taylor (1980), Calvo (1983) and Golosov and Lucas (2007), are nested under different combination of the remaining two parameters. We discuss the identification of these parameters using observations on the shape of the size-distribution of price changes (e.g. its kurtosis) and the actual cost of price adjustments borne by firms. We characterize analytically the response of the aggregate economy to a monetary shock, and how it depends on the variance and kurtosis, as well as on the frequency, of price changes.

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Paper provided by Einaudi Institute for Economics and Finance (EIEF) in its series EIEF Working Papers Series with number 1318.

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Length: 63 pages
Date of creation: 2013
Date of revision: Aug 2013
Handle: RePEc:eie:wpaper:1318
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