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Sunday, September 16, 2007

Golosov and Lucas: Menu Costs and Phillips Curves

A lot of you don't believe in a Phillips curve, but I've argued that there is a short-run inflation-output tradeoff and I've cited New Keynesian models along with supporting empirical evidence to reinforce that position. But when I make that argument, you should cite this paper by Golosov and Lucas to argue against the existence of a significant inflation-output tradeoff. The paper argues that if there is a Phillips curve, the inflation-output tradeoff is pretty steep, steep enough so that nominal shocks are "nearly neutral":

Menu Costs and Phillips Curves, by Mikhail Golosov and Robert E. Lucas Jr., Journal of Political Economy, 2007, vol. 115, no. 2
[open link]: I. Introduction This paper develops a model of a monetary economy in which firms must pay a fixed cost—a "menu cost"—in order to change nominal prices. Menu costs are interesting to macroeconomists because they are often cited as a microeconomic foundation for a form of "price stickiness" assumed in many New Keynesian models. Without sticky prices these models would not exhibit the real effects of monetary shocks—Phillips curves—that they are designed to analyze.

Under menu costs, any individual price will be constant most of the time and then occasionally jump to a new level. Thus the center of the model will be the firm's pricing decision to reprice or not to do so. Many New Keynesian models do not examine this decision but instead rely on a simplifying assumption proposed by Calvo (1983) that the waiting time between repricing dates is selected at random from an exponential distribution: Firms choose the size of price changes but not their timing.

As many others are, we are skeptical that the Calvo model provides a serviceable approximation to behavior under menu costs.[1] One reason is that the assumption of a constant repricing rate cannot fit the fact that repricing is more frequent in high-inflation environments. But a second, more important, reason was discovered by Caplin and Spulber (1987), who constructed a theoretical example of an economy with menu costs in which only a small fraction of firms reprice yet changes in money growth are neutral. In their example, there is a stationary distribution of firms' relative prices, and as a monetary expansion proceeds, the firms at the low end of this distribution reprice to the high end. The repricing rate is very low—prices are very "sticky"—but no price stickiness can be seen at the aggregate level. The key to the example is that the firms that change price are not selected at random but are rather those firms whose prices are most out of line.

The Caplin and Spulber example is well designed to exhibit this selection effect, but it is unrealistic in too many respects to be implemented quantitatively. In this paper we capture the selection effect in a new model of menu cost pricing, designed so that it can be realistically calibrated using a new data set on prices, assembled and described by Bils and Klenow (2004) and Klenow and Kryvtsov (2005). This estimation makes use of both cross-section and time-series evidence on the prices of narrowly defined individual goods and summary statistics on the frequency of individual price changes.

The average annual inflation rate in these data is about 2.5 percent and on average 22 percent of prices were changed each month, yet the average price change conditional on a price increase was 9.5 percent. These numbers cannot be understood with a model in which sellers react to aggregate inflation shocks only. We introduce a second, idiosyncratic shock chosen to rationalize the magnitude of the price changes that do occur at the individual market level. In order to keep the variances of relative prices from growing over time, we require this second shock to be mean-reverting. A model with these features is described in detail in Sections II and III, and the calibration is described in Section IV.

Our main finding is that even though monetary shocks have almost no impact on the rate at which firms change prices, the shocks' real effects are dramatically less persistent than in an otherwise comparable economy with time-dependent price adjustment. Simulations of the model's responses to a one-time impulse of inflation show small and transient effects on real output and employment (figs. 4a and b in Sec. V), in contrast to much larger and more persistent responses of the same model with Calvo pricing. Figure 6 compares before and after distributions of individual prices to illustrate the reason for these different responses. In the menu cost model, a positive aggregate shock induces the lowest-priced firms to increase prices. At the same time, it offsets negative idiosyncratic shocks, and some firms that would otherwise have decreased prices choose to wait. As a result, the lowest-priced firms do most of the adjusting, their adjustments are large and positive, and the economywide price level increases quickly to reflect the aggregate shock. In the Calvo setting, in contrast, firms get the opportunity to reprice randomly, many firms reprice even though they were already close to their desired price, and the average response of prices to the shock is much smaller. It takes longer for the monetary shock to be reflected in prices, and impulse responses become more persistent. ...

...

VII.      Conclusions We have constructed a model of a monetary economy in which repricing of goods is subject to a menu cost and studied the behavior of this economy numerically. The model is distinguished from its many predecessors by the presence of idiosyncratic shocks in addition to general inflation. ...

We next used the model to calculate the responses of output, employment, and prices to an unanticipated increase in money, equivalent in our setup to an impulse in the nominal wage. The predicted output responses were small and transient, bearing little resemblance to the response characteristics of New Keynesian models based on time-dependent pricing. ...

With a realistic inflation variance, this model can account for perhaps one-tenth of the observed variance of U.S. real consumption about trend. A Phillips curve estimated from data generated by the model implies that a one-percentage-point reduction in the inflation rate will depress production by 0.05 percent.

In summary, the model we proposed and calibrated to microeconomic evidence on U.S. pricing behavior does a remarkably good job of accounting for behavior differences between countries with very different inflation rates. It does not appear to be consistent with large real effects of monetary instability. These results seem to us another confirmation of the insight provided by the much simpler example of Caplin and Spulber (1987) that even when most prices remain unchanged from one day to the next, nominal shocks can be nearly neutral: The prices that stay fixed are those for which stickiness matters least, and the prices that are far out of line are the ones that change. Figure 5 substantiates the quantitative importance of this effect.

    Posted by on Sunday, September 16, 2007 at 12:15 AM in Academic Papers, Economics, Inflation, Macroeconomics | Permalink  TrackBack (0)  Comments (7)

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