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Optimal Price and Inventory Adjustment in an Open-Economy Model of the Business Cycle

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  • Robert P. Flood
  • Robert J. Hodrick

Abstract

This paper develops an open-economy macroeconomic model which can be used to interpret the observed fluctuations in output, inventories,prices,and exchange rates in the medium-sized economies of the world. The model is consistent with the major empirical regularities that have been discovered in studies of business cycles as closed-economy phenomena and in empirical studies of prices and exchange rates. The empirical regularities are (i) changes in the nominal money supply cause real output fluctuations, (ii) deviations of output from a "natural rate" show persistence, (iii)exchangerates are more volatile than nominal prices of goods, and (iv) depreciations of the currency coincide with deteriorations of the terms of trade. A controversial aspect of the model is that only unperceived money has real effects. The channel through which these effects arise involves a misperception by rational maximizing firms of the true demand that they will face after having set prices. The firms learn about their environment from equilibrium asset prices, and the dynamics of the model reflect the optimal response of inventory-holding firms rather than ad hoc price dynamics.

Suggested Citation

  • Robert P. Flood & Robert J. Hodrick, 1983. "Optimal Price and Inventory Adjustment in an Open-Economy Model of the Business Cycle," NBER Working Papers 1089, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:1089
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    Cited by:

    1. Robert P. Flood & Robert J. Hodrick, 1986. "Money and the Open Economy Business Cycle: A Flexible Price Model," NBER Working Papers 1967, National Bureau of Economic Research, Inc.
    2. Michael Kiley, 2002. "The lead of output over inflation in sticky price models," Economics Bulletin, AccessEcon, vol. 5(5), pages 1-7.
    3. Obstfeld, Maurice & Stockman, Alan C., 1985. "Exchange-rate dynamics," Handbook of International Economics,in: R. W. Jones & P. B. Kenen (ed.), Handbook of International Economics, edition 1, volume 2, chapter 18, pages 917-977 Elsevier.
    4. McCallum, Bennett T., 1994. "A semi-classical model of price-level adjustment," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 41(1), pages 251-284, December.
    5. Aizenman, Joshua, 1989. "Market power and exchange rate adjustment in the presence of quotas," Journal of International Economics, Elsevier, vol. 27(3-4), pages 265-282, November.
    6. Aizenman, Joshua, 1989. "Monopolistic competition, relative prices, and output adjustment in the open economy," Journal of International Money and Finance, Elsevier, vol. 8(1), pages 5-28, March.
    7. Joshua Aizenman, 1985. "Monopolistic Competition and Deviations from PPP," NBER Working Papers 1552, National Bureau of Economic Research, Inc.
    8. repec:ebl:ecbull:v:5:y:2002:i:5:p:1-7 is not listed on IDEAS

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