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Monetary Shocks with Observation and Menu Costs

Francesco Lippi, Luigi Paciello () and Fernando Alvarez
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Fernando Alvarez: University of Chicago

No 439, 2012 Meeting Papers from Society for Economic Dynamics

Abstract: We compute the impulse response to an aggregate monetary shock in a general equilibrium model where firms set prices subject to observation and menu costs. The firm optimally decides when to "review" costly information on the adequacy of its price. Upon each review, the firm chooses whether to adjust its price, one or more times, before the next price review. Each price adjustment entails paying a menu cost. In Alvarez, Lippi, and Paciello (2011) we show that the firm's choices map into several statistics: the frequency of price reviews, the frequency of price adjustments, the size-distribution of price changes. In this paper we use those results to obtain a measure of the relative size of observation and adjustment costs from available micro data in the United States. We study how the predictions about the aggregate effects of monetary shocks depend on the relative size of the information and adjustment frictions. We find that unexpected monetary shocks have sizable and persistent impact on aggregate output. We find that menu costs account for about one quarter of the cumulated output response to monetary shocks. We show that menu costs affect the transmission of monetary shocks to aggregate output through two channels: on one side menu costs affect the decision of adjusting prices conditional on an observation; on the other side, menu costs affect the decision of how frequently to observe the state. We find that these two channels are equally important in determining the impact of menu costs on the transmission of monetary shocks to aggregate output in the United States.

Date: 2012
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Working Paper: Monetary Shocks with Observation and Menu Costs (2013) Downloads
Working Paper: Monetary Shocks with Observation and menu Costs (2013) Downloads
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