Paper #1532

Title:

Menu costs, uncertainty cycles, and the propagation of nominal shocks

Authors:

Isaac Baley and J. Andrés Blanco

Date:

July 2016

Abstract:

Nominal shocks have long-lasting effects on real economic activity, beyond those implied by standard models that target the average frequency of price adjustment in micro data. This paper develops a price-setting model that explains this gap through the interplay of menu costs and uncertainty about idiosyncratic productivity. Uncertainty arises from firms' inability to distinguish between permanent and transitory productivity changes. Upon the arrival of a productivity shock, a firm's uncertainty spikes up and then fades with learning until the next shock arrives. These uncertainty cycles, when paired with menu costs, generate recurrent episodes of high adjustment frequency followed by episodes of low adjustment frequency at the firm level. A decreasing hazard rate of price adjustment results, as in the data. Taking into account this pricing behavior amplifies the persistence and reduces the pass-through of nominal shocks.

Keywords:

Menu costs, uncertainty, information frictions, monetary policy, hazard rates.

JEL codes:

D8, E3, E5

Area of Research:

Macroeconomics and International Economics

Published in:

American Economic Journal: Macroeconomics 2019, 11(1): 276–337
With the title:
Firm Uncertainty Cycles and the Propagation of Nominal Shocks

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