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

  • Daley, Clayton

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.

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File URL: http://mpra.ub.uni-muenchen.de/4012/1/MPRA_paper_4012.pdf
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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 4012.

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Date of creation: 11 Jul 2007
Date of revision: 11 Jul 2007
Handle: RePEc:pra:mprapa:4012
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  1. N. Gregory Mankiw & Ricardo Reis, 2001. "Sticky information versus sticky prices: a proposal to replace the New-Keynesian Phillips curve," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  2. 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.
  3. Barro, Robert J., 1976. "Rational expectations and the role of monetary policy," Journal of Monetary Economics, Elsevier, vol. 2(1), pages 1-32, January.
  4. N. Gregory Mankiw & Ricardo Reis, 2006. "Pervasive Stickiness," Harvard Institute of Economic Research Working Papers 2111, Harvard - Institute of Economic Research.
  5. Barro, Robert J, 1972. "A Theory of Monopolistic Price Adjustment," Review of Economic Studies, Wiley Blackwell, vol. 39(1), pages 17-26, January.
  6. 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.
  7. Sims, Christopher A., 2003. "Implications of rational inattention," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 665-690, April.
  8. Olivier Coibion, 2010. "Testing the Sticky Information Phillips Curve," The Review of Economics and Statistics, MIT Press, vol. 92(1), pages 87-101, February.
  9. Robert J. Gordon, 1981. "Output Fluctuations and Gradual Price Adjustment," NBER Working Papers 0621, National Bureau of Economic Research, Inc.
  10. Peter J. Klenow & Jonathan L. Willis, 2006. "Sticky information and sticky prices," Research Working Paper RWP 06-13, Federal Reserve Bank of Kansas City.
  11. Allan H. Meltzer, 1995. "Information, sticky prices and macroeconomic foundations," Proceedings, Federal Reserve Bank of St. Louis, issue May, pages 101-118.
  12. Dennis W. Carlton, 1986. "The Rigidity of Prices," NBER Working Papers 1813, National Bureau of Economic Research, Inc.
  13. Laurence Ball & David Romer, 1987. "The Equilibrium and Optimal Timing of Price Changes," NBER Working Papers 2432, National Bureau of Economic Research, Inc.
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