On Endogenously Staggered Prices

Abstract

Taylor's model of staggered contracts is an influential explanation for nominal inertia and the persistent real effects of nominal shocks. However, in standard imperfect competition models, if agents are allowed to choose the timing of pricing decisions, they will typically choose to synchronize. This paper provides a simple model of imperfect competition which produces stable staggering. Our argument relies on strategic interaction at two levels-between firms within an industries, and across industries-and produces a continuum of staggered price equilibria. These equilibria are strict, and hence stable under a simple adaptive learning process. An enduring problem for business cycle theory is an explanation for the persistent effects of nominal shocks. Explaining persistence is particularly problematic for theories based on nominal shocks, as opposed to real shocks. This is because rational expectations implies that nominal shocks themselves cannot be serially correlated, since nominal shocks are the deviation of realized nominal magnitudes from expected values. In two important papers, Taylor (1979, 1980) provided an argument as to why a nominal shock can have persistent effects. Taylor's argument required two important assumptions. First, he assumed that firms could adjust prices' only in alternate periods, an assumption which may be justified by menu or information costs. Taylor's second assumption was that price-setting was staggered-half the firms were constrained to adjust prices in odd periods, while the other half were allowed to adjust prices in even periods. These two assumptions combined to provide dramatic results on nominal inertia the adjustment of prices to a nominal shock is slow, and hence output effects are long lasting. Taylor's results on persistence arise due to strategic complementarity between price-setting decisions. This implies that each firm's optimal price is an increasing function of the aggregate price level. If a shock arrives in an even period, firms in the even cohort will not adjust fully to the nominal shock since firms in the odd cohort have fixed prices in the current period. Furthermore, with rational expectations, the even cohort also takes into account the fact that its own failure to adjust fully will also make for partial adjustment in future periods. This elegant story has made Taylor's model possibly the most influential of New-Keynesian models, by providing a dynamic setting within which small nominal rigidities may result in persistent nominal inertia.