Price decomposition and asymmetry in various regimes of the economy

Abstract

This paper decomposes price into its 2 major constituents, namely markup (Mkp) and marginal cost (MC) with which a Markov-switching VAR with fixed transition probabilities is estimated. Since the proposed pair of variables has not been extensively analysed, a theoretical model that derives markups and marginal costs as functions of parameters and shocks is developed to extract identifying restrictions for the VAR. In the empirical exercise, a non-linear representation of GIRFs is obtained that allows the analysis of 3 different regimes the economy enters and observe any potential sign or size asymmetries in the responses for each regime. We document that due to the opposite movement of Mkp and Mc in all regimes, inflation is less volatile in the recessionary state than in the expansionary state. In addition, we find that larger shocks have a lower (as % of the magnitude of the shock) and less persistent effect on inflation than shocks of a lower magnitude.