Strengthening the Micro-Foundations of Price Adjustment in New Keynsian Macroeconomic Models

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Understanding price adjustment is central for understanding how monetary policy interacts with the business cycle. The primary goal of the project is to develop a framework that allows for the analysis aggregate output and inflation dynamics in a setting that is consistent with the microeconomic evidence on price adjustment. The first challenge is to simultaneously explain both the vast heterogeneity in price dynamics at the microeconomic level and the seeming sluggishness in the response of the aggregate price level. The second challenge is to develop a model in which firms are allowed to adjust their prices whenever they want, and not to assume sluggishness at the microeconomic level by assuming that prices are changed only at given points of time. To this end, the project develops a simple structural model of inflation and output dynamics that is both analytically tractable and endogenizes pricing decisions. At the microeconomic level, firms face idiosyncratic shocks and fixed costs of adjusting prices. The research cuts through the usual difficulties in solving and aggregating such models by placing restrictions on the distribution of idiosyncratic shocks and also by focusing on a local approximation around a zero-inflation steady state. The resulting Phillips curve is similar in form to the standard New Keynesian Phillips curve expect up to a parameter that reflects the fact that when firms are free to adjust their prices when they want, the firms that adjust their prices tend to be the firms with the most to gain. With the inclusion of idiosyncratic shocks, the model is able to match microeconomic data on the size and frequency of price adjustment. For a given frequency of price adjustment, the model illustrates how allowing prices to adjust endogenously introduces greater nominal flexibility than a corresponding time-dependent framework. The analytic simplicity of the model, however, allows the introduction of complex general equilibrium interactions that have been found to enhance the effects of monetary policy. The research shows that with the introduction of these interactions, the model is capable generating considerable nominal stickiness in the aggregate price level and therefore substantial effects of money on output, all the while maintaining its ability to match the microeconomic evidence on price adjustment. The project proceeds to refine the framework to better match and explain additional features of the data. The equilibrium interactions that help the model explain aggregate price stickiness lead to higher than credible volatility in firm's sales. The project shows how the introduction of demand shocks can better match the evidence in this dimension. The baseline model also has difficulty generating inflation rates that are as persistent as those observed in the data. The project explores extensions of the baseline model that help it to account well for inflation dynamics. Markdowns appear different than other price changes, leading many researchers to analyze data that excludes temporary price cuts. A project element makes clear when this practice is justified and when it is not.