The Asymmetric Outcome of Sticky Price Models

Empirical evidence shows demand shocks tend to have an asymmetric effect on output: it falls by a larger amount with a contraction than it rises with an expansion. We argue that introducing nominal rigidities in a framework where agents maximise their welfare can yield such an asymmetric outcome. We show that this is the case in the Sticky Prices framework, where each period an exogenously set fraction of firms fails to adjust prices. While the solution method commonly adopted by this literature, the log-linearization, delivers a perfectly symmetric response, methods that respect the original struc- ture of the model yield an asymmetric one. We show that when products are good substitutes to each other and labour supply is inelastic, the model implies that the response of output is larger with monetary contractions than with ex- pansions, even when the shock is small. We identify the origin of the asymmetry in that when not all firms adjust prices, some goods are cheaper than others and so more heavily consumed. With a positive shock, these goods are produced by the firms that fail to adjust, so that real income is not very much affected. But with a negative shock, they are produced by firms that adjust prices, causing a large swing in real income.