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Menu Costs, Aggregate Fluctuations and Large Shocks

Listed author(s):
  • Adam Reiff

    (National Bank of Hungary)

  • Peter Karadi

    (European Central Bank)

In menu cost models, real effects of aggregate nominal shocks are sensitive to unobserved characteristics of price setting. The standard way to calibrate key pricing parameters is to match the cross-sectional distribution of price changes. We argue that this unconditional distribution contains insufficient information for a clean identification. In particular, it is consistent with parameterizations with contradictory aggregate implications: one generating sizeable real effects, the other effective money neutrality. We argue, instead, that price change observations conditional on aggregate shocks can be sufficiently informative. To show this, we utilize new micro level evidence on price responses to large value-added tax shocks. We present a new menu cost model with idiosyncratic shocks and show that our model successfully predicts the magnitude of the observed price responses, outperforming alternative pricing models. The new model generates small real effects of monetary policy shocks implying that imposing the menu cost assumption alone fails to explain robust time-series evidence finding the opposite.

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File URL: https://economicdynamics.org/meetpapers/2014/paper_914.pdf
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Paper provided by Society for Economic Dynamics in its series 2014 Meeting Papers with number 914.

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Date of creation: 2014
Handle: RePEc:red:sed014:914
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

Web page: http://www.EconomicDynamics.org/
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