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A “Local” Model of the Firm: Sticky prices and the Phillips Curve

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  • Daley, Clayton

Abstract

Assume a firm concerns itself exclusively with local shocks (copious citations including Lucas 1972 and Bomhoff 1983 validate that this type of assumption may be reasonable). Changes in a firm's production policy should occur when the actual demand in a period Dt suggests that the underlying demand function has shifted from expected demand E(Dt). Since firms face uncertainty, this is non-trivial and they must find a way to determining (given information from a single, current period) whether or not the underlying demand has changed or whether the firm has simply obtained a draw from its expected demand distribution. In a simplified model, a firm can use a concept similar to a Statistical Hypothesis Test on E(Dt) = Dt to come to this conclusion. Rather than select an arbitrary confidence threshold (alpha), a firm can reverse the process and use the "marginal" alpha (where the hypothesis is just rejected or accepted) as its confidence that the mean has changed, allowing it to update its expectations to E(Dt+1) = (1-a) * E(Dt) + a * (Dt) and price accordingly. By weighting new demand information using this "confidence factor," the model introduces significant and persistent rigidity around NAIRU/equilibrium. This model is also powerful because it explains the qualified success of threshold like behaivor in classical "menu cost" theories (as the threshold reflects the classic hypothesis test strategy), behavior similar to a learning model (via the weighted introduction of new data) and seeming information lags (via the low confidence in new information immediately after shifts), among others.

Suggested Citation

  • Daley, Clayton, 2007. "A “Local” Model of the Firm: Sticky prices and the Phillips Curve," MPRA Paper 4012, University Library of Munich, Germany, revised 11 Jul 2007.
  • Handle: RePEc:pra:mprapa:4012
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    File URL: https://mpra.ub.uni-muenchen.de/4012/1/MPRA_paper_4012.pdf
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    References listed on IDEAS

    as
    1. Olivier Coibion, 2010. "Testing the Sticky Information Phillips Curve," The Review of Economics and Statistics, MIT Press, vol. 92(1), pages 87-101, February.
    2. N. Gregory Mankiw & Ricardo Reis, 2002. "Sticky Information versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve," The Quarterly Journal of Economics, Oxford University Press, vol. 117(4), pages 1295-1328.
    3. Allan H. Meltzer, 1995. "Information, sticky prices and macroeconomic foundations," Review, Federal Reserve Bank of St. Louis, issue May, pages 101-118.
    4. Laurence Ball & David Romer, 1989. "The Equilibrium and Optimal Timing of Price Changes," Review of Economic Studies, Oxford University Press, vol. 56(2), pages 179-198.
    5. Blinder, Alan S, 1991. "Why Are Prices Sticky? Preliminary Results from an Interview Study," American Economic Review, American Economic Association, vol. 81(2), pages 89-96, May.
    6. Carlton, Dennis W, 1986. "The Rigidity of Prices," American Economic Review, American Economic Association, vol. 76(4), pages 637-658, September.
    7. Klenow, Peter J. & Willis, Jonathan L., 2007. "Sticky information and sticky prices," Journal of Monetary Economics, Elsevier, vol. 54(Supplemen), pages 79-99, September.
    8. Gordon, Robert J, 1981. "Output Fluctuations and Gradual Price Adjustment," Journal of Economic Literature, American Economic Association, vol. 19(2), pages 493-530, June.
    9. N. Gregory Mankiw & Ricardo Reis, 2006. "Pervasive Stickiness," American Economic Review, American Economic Association, vol. 96(2), pages 164-169, May.
    10. Sims, Christopher A., 2003. "Implications of rational inattention," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 665-690, April.
    11. Brunner, Karl & Cukierman, Alex & Meltzer, Allan H., 1983. "Money and economic activity, inventories and business cycles," Journal of Monetary Economics, Elsevier, vol. 11(3), pages 281-319.
    12. Robert J. Barro, 1972. "A Theory of Monopolistic Price Adjustment," Review of Economic Studies, Oxford University Press, vol. 39(1), pages 17-26.
    13. Barro, Robert J., 1976. "Rational expectations and the role of monetary policy," Journal of Monetary Economics, Elsevier, vol. 2(1), pages 1-32, January.
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    More about this item

    Keywords

    phillips curve;

    JEL classification:

    • E40 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - General

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