Price Rigidity and The Granular Origin of Aggregate Fluctuations

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This award funds research in macroeconomics that will study the effect of price rigidity on the origins of aggregate fluctuations in the entire U.S. economy. This addresses one piece of a larger question about whether and how shocks at the level of a firm, industry, or economic sector affect aggregate economic outcomes. The PIs hypothesize that price rigidity, and in particular the kind of rigidity that varies between different economic sectors, is responsible for a substantial fraction of the volatility generated by aggregate shocks. The results of this research will help us understand how price rigidity interacts with factors such as firm size and connections between firms. The project has potential to improve our understanding of how to model business cycle fluctuations, as well as how to build macroeconomic policies to promote economic stability and growth. This project begins from the premise that prices can be rigid. Since prices are the key transmission mechanism of shocks, the degree of price rigidity has important implications for the transmission of sector-level productivity shocks. Price rigidity attenuates upstream and downstream responses (second-order general equilibrium effects aside). Heterogeneity in price rigidity matters as well. For example, small sectors with very flexible prices may transmit as much of a micro shock as large sectors with very rigid prices. Similar intuition applies to interconnectedness. What this means is that price rigidity changes the effective distributions of size and interconnectedness.Preliminary theoretical analysis indicates that this, in turn, changes the aggregate implications of idiosyncratic shocks. In particular,sales are no longer a sufficient statistic for the contribution of sector-specific shocks to aggregate volatility. Independently, price rigidity can also affect the identity of sectors driving aggregate fluctuations. Under price rigidity, a sector may no longer show any response while absent price rigidity, it was a very important sector for aggregate fluctuations. The first step in the research plan is to construct and calibrate a finely disaggregated general equilibrium model of the U.S. economy that includes input-output relationships as well as information on industry size and degree of price rigidity. The second step will then employ this framework to derive predictions how infrequent price changes aggregate the impact of sector-specific shocks. Finally, the authors will calibrate and simulate the model economy in order to study the quantitative importance of price rigidity.This award reflects NSF's statutory mission and has been deemed worthy of support through evaluation using the Foundation's intellectual merit and broader impacts review criteria.