Implications of State-Dependent Pricing for DSGE Model-Based Policy Analysis in Indonesia

Abstract

This paper studies the implications of state-dependent pricing in a small open-economy dynamic stochastic general equilibrium (DSGE) model for Indonesia. I show that variations in the timing and frequency of price adjustment inherent in a state-dependent pricing assumption could have important implications for DSGE model-based policy analysis in Indonesia. This extensive margin effect produces disparities in the conditional variance decompositions and the impulse responses to various shocks responsible for business cycle fluctuations. An investigation into the impact of COVID-19 pandemic shocks indicates that such variations non-trivially affect the analysis on the appropriate degree of monetary policy response to the shocks. A state-dependent pricing model would call for a greater degree of monetary easing in response to the COVID-19 pandemic, than that prescribed by a traditional time-dependent pricing model. The broader implication is clear. For modelling and analyzing the Indonesian economy, in which the inflation rates have historically been moderate-to-high and highly variable, state-dependent pricing is an essential model feature.