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Monetary Policy obeying the Taylor Principle Turns Prices into Strategic Substitutes

Author

Listed:
  • Camille Cornand

    () (Univ Lyon, CNRS, GATE L-SE UMR 5824, F-69131 Ecully, France)

  • Frank Heinemann

    () (Technische Universitaet Berlin, Chair of Macroeconomics, H 52 - Strasse des 17. Juni 135 - 10 623 Berlin, Germany)

Abstract

Monetary policy affects the degree of strategic complementarity in firms’ pricing decisions if it responds to the aggregate price level. In normal times, when monopolistic competitive firms increase their prices, the central bank raises interest rates, which lowers consumption demand and creates an incentive for firms to reduce their prices. Thereby, monetary policy reduces the degree of strategic complementarities among firms’ pricing decisions and even turns prices into strategic substitutes if the effect of interest rates on demand is sufficiently strong. We show that this condition holds when monetary policy follows the Taylor principle. By contrast, in a liquidity trap where monetary policy is restricted by the zero lower bound, pricing decisions are strategic complements. Our main contribution consists in relating the determinacy and stability of equilibria to strategic substitutability in prices. We discuss the consequences for dynamic adjustment processes and some policy implications.

Suggested Citation

  • Camille Cornand & Frank Heinemann, 2018. "Monetary Policy obeying the Taylor Principle Turns Prices into Strategic Substitutes," Working Papers 1805, Groupe d'Analyse et de Théorie Economique Lyon St-Étienne (GATE Lyon St-Étienne), Université de Lyon.
  • Handle: RePEc:gat:wpaper:1805
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    References listed on IDEAS

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    More about this item

    Keywords

    monopolistic competition; monetary policy rule; pricing decisions; strategic complementarity; strategic substitutability;

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games

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