Multi-Sectoral Cascading and Price Dynamics - A Bayesian Econometric Evaluation

Recent evidence by Bils and Klenow (2004) and Klenow and Kryvstov (2003) shows that the average price duration for US CPI-basket goods is in the order of one to two quarters, challenging the monetary business cycle research to try and explain how short price durations can nevertheless generate a large degree of aggregate inflation persistence. We empirically test the relevance of a cascading structure of production as an explanation for short price durations and large aggregate inflation persistence. The final good is produced through a chain of intermediate goods, which undergo several processing stages. At each stage the price is set in nominal terms, and can be adjusted only at random intervals. Though each individual price is adjusted frequently, because the final good price embeds the intermediate price movements, it will turn out to have a large degree of stickiness. We estimate the model using Bayesian techniques to evaluate the relative role of indexation, pricing contracts length, and cascading production structure in the US postwar data. The estimation shows that short pricing contracts within the standard Calvo pricing mechanism are compatible with large inflation persistence, and inflation indexation turns out to play a much less relevant role - in other words, it ends up being a reduced-form model for the cascading production structure