Wednesday, September 26, 2012

When state-dependent pricing dominates time-dependent pricing

It should by now be obvious to anybody who has been following this blog that I do not like time-dependent pricing (aka the Calvo fairy) because it is applicable only under specific circumstances. Of course, this means that it is routinely abused because it is analytically convenient. What would it take for people to finally abandon this modeling strategy that influences so many results in the literature? The following paper?

Peter Karadi and Adam Reiff look at yet another micro-dataset (impact of large VAT changes in Hungary) and find that prices are flexible. Nothing new here. They find also that in response to large shocks, prices react in an asymmetric fashion, depending on whether the shocks are positive or negative. Calvo models are notoriously inadequate to deal with large shocks, by construction, but they are also not capable of getting any asymmetry. Take a state-dependent pricing model, and it can easily replicate these features of the data. Karadi and Reiff thus declare a clear winner among menu cost pricing models. I am not sure I would rule out information or search frictions like they do, however.

1 comment:

Kansan said...

Well, the Fed seems to have learned with Q3 that state-dependent beats time-dependent. I wish it would do the same with the Federal funds rate.