MACROECONOMIC PRICE AND QUANTITY RESPONSES WITH HETEROGENEOUS PRODUCT MARKETS

Abstract

THIS paper examines some of the implications of imperfect competition in product markets for the macroeconomic properties of the economy. Most, if not all, economies are composed of a variety of product (and labour) markets that function in different ways. At the partial equilibrium level, the different sectors of the economy may respond in different ways to changes, such as an increase in demand. However, the overall response of the macroeconomy to (say) an increase in the money supply will depend very much on the generalequilibrium interactions between these different sectors. Most papers on imperfect competition and macroeconomics have tended to make assumptions about household preferences which greatly limit the possible interactions across sectors (e.g. by assuming constant budget shares or elasticities of demand). Furthermore, it is also common to adopt a representative sector methodology in which relative output prices cannot vary. I will argue that the macroeconomic externalities across different types of markets can be particularly signficant when those markets are heterogeneous. As such, this paper extends the approach of Blanchard and Kiyotaki (1987) and Cooper and John (1988) which tackle the issue of macroeconomic externalities in a 'representative sector' framework. The paper presents a simple stylized model which focuses on a key macroeconomic issue: how an increase in nominal aggregate demand is divided between price and quantity changes. There are two general lessons to be drawn from this exercise. First, that the macroeconomic response of the economy to an increase in the money supply depends on the precise composition of the economy: in our model, we provide scenarios that range from a Keynesian Pareto-improving pure output response (Propositions 1, 2), to a classical pure price response (Proposition 3). Secondly, we argue that the presence of nominal rigidities in some sectors can spill over to the rest of the economy, leading to prices becoming more rigid in other sectors. This would indicate that the new Keynesian menu-cost theory of economic fluctuations (see Akerlof and Yellen 1985; Mankiw 1985; Rotemberg, 1982; inter alia) does not require menu-costs in all industries; it may be enough to have menu-costs in only some (possibly small) proportion of sectors to generate significant price rigidity.