A tractable menu cost model with an aggregate markup drift
Summary
Focus
The author examines a model of price stickiness, a key building block of modern monetary economics. In the model, firms on average face a steady increase in their nominal costs. The rising costs reduce their profits unless they raise prices. However, changing prices incurs a fixed cost, often called a "menu cost". In this setting, the author derives the equations sufficient to examine the dynamics of inflation and other macroeconomic variables.
Contribution
Most existing menu cost models are complex and require computationally intensive methods to solve. While a few simpler models exist, they only describe the situation in which the frequency of firms' price changes is constant over time. This does not match empirical observations during periods of relatively high inflation. The model in this paper is different. It matches the observed link between inflation and the frequency of price changes. At the same time, it remains simple enough to analyse.
Findings
The analysis reveals two key insights of the model. First, the model captures the positive correlation between the inflation rate and the frequency of price changes in the data. Second, it derives an explicit equation for the Phillips curve, which represents the relationship between the inflation rate and firms' costs. This equation includes new terms that make inflation more sensitive to shocks in the economy. Overall, the author provides a new framework to study macroeconomic phenomena, especially in inflationary environments.
Abstract
This paper extends the menu cost model of Gertler and Leahy (2008) by introducing a drift in the aggregate markup. Assuming that the drift is always negative and not large, consistent with moderate and positive trend inflation, the paper analytically characterizes firms' value function and markup distribution. It derives explicit equations sufficient to close the model in general equilibrium, making the calculation of impulse responses to aggregate shocks as easy as in conventional representative-agent New Keynesian models. In addition, the paper shows two implications of the model. First, the model replicates the empirically observed positive correlation between the inflation rate and the frequency of price changes. Second, the model yields an explicit equation representing the Phillips curve, with additional terms that make the inflation rate more responsive to aggregate shocks.
JEL Classification: E23, E31
Keywords: menu cost, Phillips curve, trend inflation, frequency of price changes