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Price plans and the real effects of monetary policy

Fernando Alvarez and Francesco Lippi
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Fernando Alvarez: University of Chicago

No 549, 2016 Meeting Papers from Society for Economic Dynamics

Abstract: Transitory price changes are prominent in the data but do not fit neatly in standard sticky price models. We present a model where a firm chooses a “price plan†, namely a set of 2 prices each of which can be freely posted at each moment. While price changes between prices within the plan are free, the plan can be changed only subject to a fixed menu cost. This setup generates a persistent “reference†price level and short lived deviations from it, as in many datasets and a decreasing hazard function for price changes. We analytically solve for the optimal policy and for the cumulative impulse response function of output to a monetary shock. We compare the economy with the 2-price plan to a menu-cost economy (i.e. a plan with 1 price) featuring the same number of persistent price changes. We show that, for a small monetary shock, the introduction of a plan with 2 prices yields a cumulative output response that is 1/3 of the one produced by the menu cost economy. The smaller real effect is due to the flexibility delivered by the temporary price changes that are used by firms to respond to the shock.

New Economics Papers: this item is included in nep-dge and nep-mon
Date: 2016
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