Friday, August 10, 2012

Flexible-price inflation and monetary policy

Are prices flexible or not? There is no doubt that there is some rigidity. But does it actually matter? This debate in the macroeconomic literature has surprisingly side-stepped an important aspect of price rigidity: not all prices are equally rigid. While this has been empirically demonstrated many times, it never really made it into a model.

Stephen Millard and Tom O’Grady take a standard two-sector model and label one sector "sticky-price" and the other "flexible-price." They go through the usual motions of assessing their model and find that it can account for much of what is going on in the economy. But more interesting is their idea that there is a lot of useful information in looking at the inflation rates in the two sectors. Flexible prices react faster to current output gaps, while sticky ones should contain more information about expectations on future conditions, in particular inflation. And it should not be too hard to compute these statistics with current data collection. We already have several works that categorize goods by price stickiness.

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