The Determinants of Price Change: Evidence from a Survey of Firms

Abstract

Price stability are important for macroeconomic stability, especially for the economies, which are facing macroeconomic instability. Contractionary monetary policy can play an important role in minimizing the frequency of price change, so for effective monetary policy, it is necessary to identify the determinants of price setting behaviour. The objective of the study is to determine the patterns of price setting of firms and responses of firms to economic shocks, i.e. changes in demand and supply side factors, the role of firm characteristics, institutional and other factors in determining the channel of adjustment after these shocks. The data is collected through stratified frandom samplling from 342 firms, located in four Industrial estates of Khyber Pakhtunkhwa. Price setting behavior is measured through importance of demand and cost shocks for price change. To estimate the effects of determinants of price change, models are estimated through logistic technique. Firms’ likelihood of price increases higher than that to price decrease in response to both demand and supply shocks. Furthermore, supply-side factors lead to higher frequency of price change than demand-side factors do. The cost of raw material and cost of energy are the most important causes of price change, both for the price increase and decrease. Demand and cost shocks are important determinants of price change for imperfectly competitive firms, backward-looking firms, firms run by managers having more information about economic conditions, while credibility of central bank is important determinant of price change in case of demand shocks only. Size of firms and information set regarding expected inflation do not have any effect. For effective monetary policy of Pakistan, credibility of central bank has to be established to stabilize prices and pre-emptive measures should be taken on the part of central bank to counter supply shocks.