Wednesday, September 19, 2012

Prices are even less sticky when looking at households

Whether prices are sufficiently rigid to matter is an somewhat unsettled debate I have occasionally discussed on this blog. This is mostly a measurement issue. Once we know how it is in the data, we should know what model to use and how to calibrate it. The models that use price rigidity, the New-Keynesian, usually apply the concept in a rigid manner. For one, they use the much criticized Calvo fairy assumption. But they also assume that the same rigidity applies to the prices at which the firms sell their goods and to the prices at which households (or other firms) buy their goods.

As Olivier Coibion, Yuriy Gorodnichenko and Gee Hee Hong show, the reality is quite far from this last assumption. They use data from retailers in various US metropolitan areas which comprises both prices and quantities. They find that household switch easily retailers and take advantage of temporary sales. How much they do this varies through the business cycle, with an interesting implication: the effective household inflation rate is lower when unemployment is high. This implies that monetary easing becomes more difficult because household-level prices adjust 2.5 times faster than retailer-level prices.

The impact on the response of the output gap after a monetary stimulus is, however, almost identical to a model without retail switching. I suspect this is due to the fact that the model still uses Calvo pricing. Beyond the usual criticism of this assumption, here it also implies that retailers cannot take into account that households may want to switch retailers more frequently in a recession. Too bad that a very interesting result is poorly applied in this study.

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