Price-setting Decisions by Firms, Inflation, and Monetary Policy

Sales and monetary policy:

In recent research, CEP macro program members Kevin Sheedy and Bernardo Guimaraes examine the role of sales in price stickiness. Standard price series for an individual good display gradual price adjustment in steps (e.g. prices being increased once a year) but with frequent temporary sales, where prices drop drastically and return to their original level. How do we rationalize these two different phenomenon? The base price (the price when there is no sale) is only adjusted infrequently, in line with standard price stickiness models. However, firms clearly are willing to adjust prices more often, as they do in sales.

The proper treatment of sales is of crucial importance to the New Keynesian framework. Bils and Klenow (2004) count sales as price changes and calculate the median duration of a price spell across the CPI as only 4 months. Nakamura and Steinsson (2007) do not count sales, and find the median duration to be 9 months. If these two numbers are incorporated into a standard Calvo pricing model (without taking sales into account) they deliver vastly different real effects of monetary policy. Which number is correct? Kevin and Bernardo's research addresses this question by developing a model of price setting with price stickiness and sales grounded in the industrial organization framework. In contrast with simple models which suggest that the ability to have sales implies monetary neutrality, properly founding the rationale for sales in an IO framework leads to strong real effects of monetary policy. These effects are due to sales being strategy substitutes. Following a negative shock to demand an individual firm faces the incentive to increase the amount it uses sales. However, the IO rationale given for the use of sales is that they are used to attract customers who like to shop around; to attract new customers. In this case if a firm uses a sale it discourages other firms from doing so because the ability to attract new customers by having a sale is diminished since consumers who like to shop around face lower prices everywhere and will be less likely to switch to your store than if no one else was having a sale.

Thus the strategic substitutability of sales reduces the degree to which they are used in response to demand shocks, reducing the degree to which prices adjust. As an example, if the base price is completely fixed but firms are still allowed to use sales endogenously, the elasticity of price including sales to a monetary shock is only 0.1 in their model. Flexibility to use sales to the individual level does not translate to aggregate price flexibility.

Robust monetary policy and stickiness processes:

It is known that firms keep their prices fixed for long periods of time, but the exact mechanism that determines when and by how much individual firms change prices is poorly understood. Since the effects of monetary policy depend crucially on the responses of prices, one might expect that ignorance of the exact price-setting process by firms would make effective central banking nearly impossible. Kevin's research shows that, to the contrary, central banks have access to "robust" monetary policy rules that do not require them to know the patterns of price setting in the economy. He shows that it is possible to construct policy rules which are optimal for a wide class of price stickiness processes. Importantly, the rules are optimal under any of the processes, so the central bank does not need any knowledge of the process to conduct optimal policy. That is, regardless of whether price stickiness is of the Calvo, Taylor, or Wolman forms (or indeed many others) a common optimal policy exists.

Sticky prices and sticky inflation:

One thing that is known about price-setting behaviour is that the frequency of price changes varies a lot across industries. In related research Kevin asks what this implies for the speed at which economy-wide inflation responds to monetary-policy actions. He shows that in theory this should lead to faster adjustment than if all firms had the same, average delay between price changes. This is a puzzle for standard theory researchers because in practice adjustment is very slow.

However Kevin's research also offers a potential resolution: if newer prices are stickier than older prices it becomes easier to explain the high persistence of inflation. The standard forward looking New Keynesian Philips Curve cannot generate persistence in inflation, because disinflation is costless - central banks do not have to generate a recession to reduce inflation. Adding inflation persistence requires putting a lagged inflation term in the NKPC, and Kevin's research provides a way of doing this, microfounded using this extension. We expect newer prices to be stickier than old: if a firm wants to expend limited resources on the menu costs of changing prices, it will presumably spend more on changing the old prices, which will be further out of line than recently optimized prices. Hence, older prices will be changed with a higher probability than new.

To read more about Bernardo Guimaraes and Kevin Sheedy's work on price stickiness and monetary policy see:

• "Sales and Monetary Policy" [Full document in Adobe PDF] (Bernardo Guimaraes and Kevin D. Sheedy), CEP Discussion Paper 0887, November 2008
  
  
• "Robustly Optimal Monetary Policy" [Full document in Adobe PDF] (Kevin D. Sheedy), CEP Discussion Paper 0840, November 2007
  
  
• "Inflation Persistence When Price Stickiness Differs Between Industries" [Full document in Adobe PDF] (Kevin D. Sheedy), CEP Discussion Paper 0838, November 2007
  
  
• "Intrinsic Inflation Persistence" [Full document in Adobe PDF] (Kevin D. Sheedy), CEP Discussion Paper 0837, November 2007