The price effects of monetary shocks in a network economy

Abstract

Empirical evidence shows monetary shocks have two temporary effects on the distribution of prices. One, the dispersion of cross-section of prices increases in response to monetary shocks. Two, some prices change in the ‘wrong’ direction: some prices decrease in response to positive monetary shocks, and increase in response to negative monetary shocks. We present a model that generates the two effects of monetary shocks on the distribution of prices as an out-of-equilibrium phenomena. Firms are related to each other through a production network. Monetary shocks change the working capital of a subset of firms and percolate to other firms through buyer-seller linkages. Price dispersion increases because the percolation of a monetary shock through the production network causes prices to differentially deviate from their steady state values. Some prices change in the wrong direction because a shift in one firm’s demand causes a shift in another firm’s supply (and vice-versa), thereby generating complicated chains of bi-directional price changes. Monetary shocks can significantly disturb relative prices even when all prices are fully flexible.