This project studies the microeconomic umderpinnings of the inflationary process. It is widely accepted among economic theorists that inflation, that is changes in the aggregate price level, is characterized by discrete jumps in individual prices. This work analyzes the theoretical feasibility of aggregating those discrete price changes into a smooth time path for an aggregate price level. Fundamental to such a study is the interaction of the firms in setting pricing policies. If firms follow identical real price cycles in setting prices, then consistent aggregation is feasible. However, there are important reasons why such uniformity in pricing policies among independent firms might not converge to an economic equilibrium. Specifically the project employs a duopoly model where demand depends on current real prices. Each firm faces a choice of a price path or price strategy which maximizes the present value of profits over a time horizon. The salient feature of the model is the discontinuous pattern of nominal price adjustments. The project characterizes those conditions under which the assumptions of a smoothly changing aggregate price level is consistent with economic equilibruim. %%% Among the most difficult and important areas of economic research is the characterization of price movements, production, and pricing strategies of firms in oligopolistic markets. Such markets by definition have only a few firms which account for all the industry's output, and are very prevalent in both the U.S. and international economy. Automobile manufacturing is an example of an oligopolistic market. In such markets prices are set based on the interaction among the firms, the relative size of each firm's market share, and the incentives faced by each firm to act independently of the others. This type of interaction results in the prices set by individual firms being changed in discrete intervals rather than moving smoothly through time. However, many studies of the aggregate economy, particularly those examining inflation, assume a continuous time path for prices. This project studies the conditions under which the assumption of a smooth time path for aggregate prices is consistent with the independent setting of prices by individual firms, and with economic equilibrium. In doing so, the work adds a fundamental theoretical basis to studies of both the aggregate economy and the behavior of individual firms.
