Economic Letter 2001-24; August 24,
2001
Recent Research on Sticky Prices
This Economic Letter summarizes the papers presented at the
conference "Nominal Rigidities" held in San Francisco on June 16 under
the joint sponsorship of the Federal Reserve Bank of San Francisco, the
National Bureau of Economic Research, and the Federal Reserve Bank of
Cleveland.
Broadly speaking, the papers at the conference were concerned with
modeling the effects of policy in an economy with nominal rigidities—that
is, with prices and wages that are relatively inflexible, or "sticky."
One set of papers focused on determining the characteristics that a model
economy would require to plausibly reproduce the observed behavior of
key macroeconomic variables such as output and inflation, especially in
response to a monetary policy shock. Christiano, Eichenbaum, and Evans
find that wage rigidity (along with some other requirements) is a must,
while McGrattan finds that price rigidity is not particularly useful.
Mankiw and Reiss argue that it is more useful to think of the rigidities
as arising from the costs of acquiring and processing information, rather
than the costs of changing wages or prices. The paper by Barro and Tenreyro
has a different focus: it assumes sticky prices in only part of the economy
and looks at the role played by sticky-ness in propagating business cycles.
Their model implies that the more concentrated the industry, the more
countercyclical its prices, an implication for which they find some support
in the data. The final two papers in the conference, authored by Schmitt-Grohé
and Uribe and by Correia, Nicolini, and Teles, discuss how the prescriptions
for optimal fiscal and monetary policy that are derived in models with
flexible prices get modified when prices are assumed to be sticky. The
key finding here is that it may be advisable to pay greater attention
to stabilizing prices in an environment with sticky prices than one would
in an environment with flexible prices.
What kind of "sticky-ness" is best?
In recent years, economists have been working with models in which the
decision-making problems of firms and households are explicitly specified,
as are the environments in which they operate. More recently, within this
tradition, some economists have begun to explore the role played by "sticky"
wages and prices, that is, by prices and wages that are not free to adjust
quickly in response to changes in the environment. A key objective of
this research program has been the construction of models that produce
plausible descriptions of how a change in monetary policy affects the
economy. The first set of papers is part of this program; their analysis
can be viewed as trying to determine the best place (in the model) to
locate this sticky-ness or nominal rigidity.
Christiano, Eichenbaum, and Evans' (CEE) ask what sort of restrictions
must be imposed on a model of the economy with optimizing agents and a
richly specified environment in order to obtain the same response to a
monetary policy shock as observed in a simple description of the actual
data. In their model, both prices and wages adjust sluggishly. They find
that they can mimic the responses in the data most closely when they allow
wage contracts to have an average duration of roughly 2 quarters while
prices are allowed to be reset every 3 quarters. Wage rigidity turns out
to be the more crucial requirement of the two. Assuming that prices are
fully flexible in a world with sticky wages does not lead to results that
are very different from the case where both prices and wages are assumed
to be sticky; by contrast, assuming that prices are sticky while wages
are flexible leads to a marked deterioration in the model's performance.
McGrattan's goal is similar to CEE. She sets up a model with optimizing
households and firms as well; her focus, however, is on the role played
by sticky prices. In her model monetary policy is conducted using the
well-known Taylor rule, according to which the monetary authority sets
interest rates in response to changes in inflation and departures of output
from an estimate of its long-run trend.
McGrattan's model yields some counterfactual implications. For example,
she finds that interest rates are negatively serially correlated, in contrast
to the positive correlation observed in the data. She also finds that
in her model the response of output to a monetary shock is not as persistent
as observed in the data. Allowing for nonmonetary shocks does lead to
more persistent changes in output; however, the attempt to make output
more persistent makes the amplitude of the business cycles generated by
the model too small. Overall, McGrattan concludes that introducing sticky
prices into fully articulated models of the economy does not allow these
models to replicate the behavior of key economic data and does not help
us understand how monetary policy affects the economy.
Mankiw and Reis (MR) focus on a model where price sticky-ness is
associated with the costs of acquiring and processing the information
necessary to set prices. In their model, prices are easy to change, but
because information is assumed to diffuse only gradually through the economy,
these changes end up being based upon old estimates of the state of the
economy.
MR show how their model responds to a variety of monetary policy
shocks and compare its predictions to those from two versions of the sticky
price model which differ in their assumption about how expectations are
formed. Consider, for example, what happens when the monetary authority
announces that it will engineer a decrease in the growth rate of aggregate
demand in the near future. In the (sticky price) model with forward-looking
households and firms, the result is an increase in output, because prices
start falling when the announcement is made; with the money supply growth
rate unchanged, output goes up. By contrast, this announcement has no
effect in the (sticky price) model with backward-looking firms and households.
However, both prices and output begin to fall sharply after the monetary
authority tightens, just as they would if the authority had made no such
announcement.
MR argue that, while the predictions of both versions are hard to
reconcile with empirical observation, this is not the case for the sticky
information model. Although the timing of the responses in the sticky
information model is the same as in the backward-looking model, the magnitudes
are much smaller and, therefore, closer to what is observed in practice.
In particular, because some of the firms have been able to incorporate
the relevant information into their plans before the policy change takes
effect, output falls less than and inflation falls more quickly than it
does in the backward-looking model (once the monetary authority tightens).
Thus, a pre-announced reduction in demand leads to a contraction in output
that is smaller than it would be if the reduction were a surprise. Note
also that this contrasts sharply with the forward-looking model's questionable
prediction that output should boom after the announcement.
Barro and Tenreyro (BT) show how the existence of sticky prices in
part of the economy can play a role in the propagation of business cycles.
Their model contains two sectors: final and intermediate goods. Final
goods are assumed to be produced in a competitive environment, while the
intermediate goods sector is imperfectly competitive and produces goods
that are differentiated from each other. Assume now that there is an increase
in the degree of competition in the intermediate goods sector. This leads
to a decrease in the price of intermediate goods relative to final goods,
causing final goods firms to increase the use of intermediate goods and
thereby increase output. Labor productivity goes up, as do wages. BT show
that the same effect can be achieved through monetary policy if intermediate
goods prices are assumed to be sticky. An unexpected monetary expansion
leads to an increase in the price of final goods and temporarily reduces
the relative price of intermediate goods, causing final goods producers
to increase output.
BT neither estimate nor test this model directly, but they do test
one of its implications, namely, that the relative price of goods produced
by less competitive sectors is countercyclical; that is to say, it falls
during booms and rises during recessions. Using the growth rate of real
output as an indicator of the cycle and price data for the manufacturing
sector over the 1958-1997 period, BT find evidence suggesting that the
more concentrated the sector, the more countercyclical its relative price.
Sticky-ness and optimal policy
The final two papers address how optimal policies should be set in a
sticky price environment. These papers are part of a research program
that asks how the government (including the central bank) can finance
a given stream of expenditures while minimizing the distortions that any
method of raising revenues is likely to impose upon the economy. Using
models with flexible prices, some researchers have shown that monetary
policy should be conducted according to the Friedman rule, which calls
for a zero nominal interest rate, that is, it calls for deflation at a
rate equal to the real rate of interest. As Nobel prize winning economist
Milton Friedman originally pointed out, since money is costless to produce,
it is optimal to set the cost of holding it (which is the forgone interest)
at zero as well. Furthermore, it has been shown that if prices are flexible
and the government cannot issue debt whose value varies with the state
of the economy, the optimal inflation rate is highly volatile but uncorrelated
over time. In this setting, the government uses inflation as a non-distorting
tax on financial wealth in order to offset unanticipated changes in the
deficit. By contrast, the income tax rate remains relatively stable.
Other researchers have shown how the existence of sticky wages and
prices leads to the government's facing a tradeoff in choosing the optimal
inflation rate. The benefits of using inflation as a non-distorting tax
on financial wealth must now be balanced against the costs that inflation
imposes on firms and households who are unable to adjust prices quickly
enough. As Schmitt-Grohé and Uribe (S-GU) point out, these researchers
have assumed that the government can freely deploy some rather unusual
tools, including production or employment subsidies as well as lump sum
taxes. (Since lump sum taxes are, by definition, independent of economic
activity, they do not distort the incentives to undertake such activity.)
Given these tools, the government is able to keep the inflation rate close
to zero, so it can avoid the distortions imposed by nominal rigidities.
S-GU assume that the government does not have access to either lump
sum taxes or production subsidies. Even so, they find that optimal policy
calls for low inflation volatility. Specifically, in a model in which
firms are assumed to adjust prices roughly once every nine months, the
volatility (here defined as the standard deviation) of inflation under
sticky prices is one-fortieth of what it is under flexible prices. And
even if the parameter that governs price sticky-ness is assumed to be
ten times smaller, the volatility of inflation is still a thirteenth of
what it is under flexible prices.
Correia, Nicolini, and Teles (CTN) take up the issue of optimal fiscal
and monetary policies as well. Their key finding is that, even if prices
are sticky, a benevolent government can steer the economy to the same
equilibrium as it would if prices were flexible. In a sense, then, the
way in which prices are set becomes irrelevant to the final outcome. At
first glance, this result seems to contradict the results of the previous
authors. It turns out, however, that CTN assume that the government has
access to state-contingent debt, that is, it can vary the value of its
outstanding obligations depending upon the state of the economy. For instance,
in the case of an expensive war, the government could default on some
of its debt. It is this extra "instrument" that gives the government the
ability to attain the same equilibrium in an economy with sticky prices
that it would under flexible prices.
Bharat Trehan
Research Advisor
Conference Papers*
Barro, R. J., and S. Tenreyro. 2001. "Closed and Open Economy Models
of Business Cycles with Marked Up and Sticky Prices."
Christiano, L. J., M. Eichenbaum, and C. Evans. 2001. "Nominal Rigidities
and the Dynamic Effects of a Shock to Monetary Policy."
Correia, I., J. P. Nicolini, and P. Teles. 2001. "Optimal Fiscal
and Monetary Policy: Equivalence Results."
Mankiw, N. G., and R. Reis. 2001. "Sticky Information Versus Sticky
Prices: A Proposal to Replace the New Keynesian Phillips Curve."
McGrattan, E. R. 1999. "Predicting the Effects of Federal Reserve
Policy in a Sticky Price Model: An Analytical Approach."
Schmitt-Grohé, S., and M. Uribe. 2001. "Optimal Fiscal and
Monetary Policy under Sticky Prices."
*All papers are available at http://www.frbsf.org/economics/conferences/0106/index.html
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