Many theories of how monetary policy affects real economic activity are based on the existence of (i) costs of resetting prices, and (ii) pricing complementarities which make the firm less inclined to adjust its prices when other firms hold their prices constant. In this project we evaluate these theories by assessing some of their implications for micro-economic data.
We formulate a model of nominal rigidities based on menu costs and product-specific disturbances to cost and demand conditions, and that also allows for pricing interactions between firms. We select the model's key parameters to match observations about the cross-sectional distribution of price and quantity fluctuations at the level of individual products for one particular supermarket scanner dataset. In particular, our approach enables us to discipline the costs of resetting prices and the degree of pricing complementarities just on the basis of product-level data; previous work disciplined the choice of these parameters exclusively using aggregate data.
We then examine the implications of our model for important macro-economic questions. First, we ask whether sticky price models can plausibly generate a slow response of inflation and a large response of output from changes in monetary policy, despite the fact that prices for individual products tend to change fairly frequently. Preliminary findings suggest that the quantitative importance of the pricing complementarities that we examine is smaller than estimates that are based on aggregate data. This is because our data suggest a demand elasticity that is much lower than most existing macro estimates, but is in line with estimates from Industrial Organization.
Second, we ask whether the relative price distortions induced by steady-state inflation can lead to substantial welfare losses. Existing sticky price models base their conclusions on the welfare costs of inflation and on the conduct of optimal monetary policy on the notion that inflation induces distortions in relative prices between goods whose prices adjust, and goods whose prices remain constant, but are otherwise identical. Once our model is calibrated to account for some of these micro aspects of the data, we find that the welfare implications from distortions in relative prices are much smaller than what is suggested by previous work.
Our analysis highlights the important role of micro data in disciplining answers to macro questions. First, the parameters that determine the aggregate response of the economy to changes in monetary policy also determine how prices adjust to product-specific conditions. We can thus use information on the latter to discipline theories about the former. Second, if the welfare costs of inflation depend primarily on cross-sectional distortions between goods whose prices are adjusted and goods whose prices remain constant, these costs can be better assessed using information on the cross-sectional distribution of price fluctuations.
