Reconsideration of the P-Bar Model of Gradual Price Adjustment

Bennett McCallum

No 14163, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper compares the P-bar model of price adjustment with the currently dominant Calvo specification. Theoretically, the P-bar model is more attractive as it depends upon adjustment costs for physical quantities rather than nominal prices, while incorporating a one-period information lag. Furthermore, the resulting adjustment relation is more completely free of "money illusion," in terms of dynamic relationships, and therefore satisfies the natural rate hypothesis of Lucas (1972), which is not satisfied by the Calvo model in any of its variants. Along the way, it shows that both the P-bar and Calvo models can be formulated in distinct versions in which current real wages are, or are not, allocative. Quantitatively, for a given calibration of the demand parameters, the implied time series properties of the inflation rate, output gap, and nominal interest rate are determined for various policy parameters, and are compared with quarterly data for the U.S. economy. Neither model dominates but, overall, the comparison seems somewhat more favorable to the P-bar model and certainly does not provide support for the dominant position held by the Calvo model in current monetary policy analysis.

JEL-codes: E30 E52 (search for similar items in EconPapers)
Date: 2008-07
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
Note: EFG ME
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Citations: View citations in EconPapers (4)

Published as McCallum, Bennett T., 2008. "Reconsideration of the P-bar model of gradual price adjustment," European Economic Review, Elsevier, vol. 52(8), pages 1480-1493, November.

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