Monday, January 20, 2014

Uncertain times and price setting

Much has been written, including here, about how policy uncertainty is bad for business. Firms do not want to invest much when it is not clear what lies ahead in terms of fiscal policy, for example. This is particularly bad in countries where such uncertainty is chronic. If fiscal authorities or the government cannot get their act together, maybe the central bank can.

Isaac Baley and Julio Blanco show that if firms face uncertainty, monetary policy has less bite. The reason lies in the endogenous price formation (no Calvo fairy here). Specifically, firms are modeled to forecast their nominal costs, but the learning process is obviously imperfect. As the forecast variance increases, for example due to uncertainty about after tax returns, firms become more sensitive to new information and adjust prices more frequently, paying a menu cost. This effect is stronger than their urge to wait-and-see in the face of uncertainty. All this accelerates the transmission of information about the monetary policy, further dampening its impact. In other words, an ineffective government renders the central bank less effective as well.

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