State-Dependent Pricing and the Dynamics of Money and Output

Abstract

Standard macroeconomic models of price stickiness assume that each firm leaves its price unchanged for a fixed amount of time. We present an alternative model in which the pricing decision depends on the state of the economy. We find a method of aggregating individual price changes that allows a simple characterization of macroeconomic variables. The model produces a positive money-output correlation and an empirical Phillips curve. In addition, the impact of monetary shocks depends crucially on the current level of output, which points to a natural connection between state-dependent microeconomics and state-dependent macroeconomics. I. INTRODUCTION There is a long tradition in macroeconomics of attributing the real effects of nominal demand shocks to nominal price stickiness. In this view, if there is no change in prices when nominal demand rises, then quantities must bear the burden of adjustment. Hence nominal price rigidity provides the friction needed for nominal demand shocks to be transmitted to the real economy. Standard models of this transmission mechanism, such as Fischer [1977] and Taylor [1980], are based on the assumption that each firm leaves its price unchanged for a fixed amount of time. The main reason for considering such time-dependent pricing rules is their analytic tractability. Constraining firms to adjust their prices at prespecified times both simplifies the derivation of equilibrium strategies and allows the use of powerful time series techniques to analyze aggregate dynamics. The main disadvantage of the timedependent approach is that between price adjustments firms are not allowed to respond even to extreme changes of circumstance. This makes it difficult to know whether the qualitative effects of money in these models are the result of nominal rigidities per se or of the exogenously imposed pattern of price changes. An alternative approach to modeling price stickiness is to allow the price-setting decision to depend on the actual state of the