Monetary Policy obeying the Taylor Principle Turns Prices into Strategic Substitutes

Camille Cornand and Frank Heinemann

Working Papers from HAL

Abstract: Monetary policy affects the degree of strategic complementarity in firms' pricing decisions if it responds to the aggregate price level. In normal times, when monopolistic competitive firms increase their prices, the central bank raises interest rates, which lowers consumption demand and creates an incentive for firms to reduce their prices. Thereby, monetary policy reduces the degree of strategic complementarities among firms' pricing decisions and even turns prices into strategic substitutes if the effect of interest rates on demand is sufficiently strong. We show that this condition holds when monetary policy follows the Taylor principle. By contrast, in a liquidity trap where monetary policy is restricted by the zero lower bound, pricing decisions are strategic complements. Our main contribution consists in relating the determinacy and stability of equilibria to strategic substitutability in prices. We discuss the consequences for dynamic adjustment processes and some policy implications. Abstract Monetary policy affects the degree of strategic complementarity in firms' pricing decisions if it responds to the aggregate price level. In normal times, when monopolis-tic competitive firms increase their prices, the central bank raises interest rates, which lowers consumption demand and creates an incentive for firms to reduce their prices. Thereby, monetary policy reduces the degree of strategic complementarities among firms' pricing decisions and even turns prices into strategic substitutes if the effect of interest rates on demand is sufficiently strong. We show that this condition holds when monetary policy follows the Taylor principle. By contrast, in a liquidity trap where monetary policy is restricted by the zero lower bound, pricing decisions are strategic complements. Our main contribution consists in relating the determinacy and stability of equilibria to strategic substitutability in prices. We discuss the consequences for dynamic adjustment processes and some policy implications.

Keywords: monopolistic competition; strategic complementarity; pricing decisions; monetary policy rule; strategic substitutability (search for similar items in EconPapers)
Date: 2018
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
Note: View the original document on HAL open archive server: https://shs.hal.science/halshs-01759692v1
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Citations: View citations in EconPapers (3)

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Related works:
Journal Article: Monetary policy obeying the Taylor principle turns prices into strategic substitutes (2022)
Working Paper: Monetary policy obeying the Taylor principle turns prices into strategic substitutes (2022)
Working Paper: Monetary Policy obeying the Taylor Principle Turns Prices into Strategic Substitutes (2018)
Working Paper: Monetary Policy Obeying the Taylor Principle Turns Prices Into Strategic Substitutes (2018)
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