Greater Price Flexibility Research Articles

Policy Paradoxes in the New Keynesian Model

Abstract The common sticky-prices New-Keynesian model behaves differently in a zero-lower bound environment. Fiscal and forward guidance multipliers can be very large. Positive supply shocks, such as an increase in productivity, will lower production, and increased price flexibility can exacerbate such a decline in output (as well as amplifying the effects of other shocks). These results are fragile and disappear under a plausible alternative to sticky prices (sticky information): Fiscal and monetary multipliers are smaller, positive supply shocks raise output, and greater price flexibility, in the sense of more frequent updating of information, moves the economy's response toward the neoclassical benchmark.

Policy paradoxes in the New Keynesian model

The common sticky-prices New-Keynesian model behaves differently in a zero-lower bound environment. Fiscal and forward guidance multipliers can be very large. Positive supply shocks, such as an increase in productivity, will lower production, and increased price flexibility can exacerbate such a decline in output (as well as amplifying the effects of other shocks). These results are fragile and disappear under a plausible alternative to sticky prices (sticky information): Fiscal and monetary multipliers are smaller, positive supply shocks raise output, and greater price flexibility, in the sense of more frequent updating of information, moves the economy's response toward the neoclassical benchmark.

Policy Paradoxes in the New Keynesian Model

The most common New-Keynesian model--with sticky-prices--has potentially implausible implications in a zero-lower bound environment. Fiscal and forward guidance multipliers can be implausibly large. Moreover, the sticky-price model implies that positive supply shocks, such as an increase in productivity, will lower production, and that increased price flexibility can exacerbate such a decline in output (as well as amplifying the effects of other shocks). These results are fragile and disappear under a plausible alternative to sticky prices--sticky information: Fiscal and monetary multipliers are smaller, positive supply shocks raise output, and greater price flexibility, in the sense of more frequent updating of information, moves the economy's response toward the neoclassical benchmark. These results suggest caution in drawing policy lessons from a single, sticky-price framework. Finally, we highlight how strategies akin to nominal-income targeting can enhance the ability of policymakers to affect demand in sticky-price and sticky-information models.

Vertical Differentiation with Variety-Seeking Consumers

We analyze price and quality competition in a vertically differentiated duopoly in which consumers have a preference for variety. The preference for variety is a consequence of diminishing marginal utility for repeated experiences with the same product. We find consumer variety seeking can either soften or intensify price competition, depending on the difference in firm qualities and the strength of consumer preference for variety. When the qualities are similar (or the consumer preference for variety is strong), prices and profits are higher than would be obtained in the absence of variety seeking. On the other hand, if qualities differ enough (or the preference for variety is weak), stronger preferences for variety are associated with more intense price competition and lower profits. When firms set their qualities before competing on price and the range of feasible qualities is restricted such that variety seeking softens competition, competing firms choose to minimally differentiate themselves from each other. The preference for variety can drive the firms to offer multiunit discounts, and the greater price flexibility from these discounts does not necessarily reduce profits relative to simple unit pricing. This paper was accepted by J. Miguel Villas-Boas, marketing.

Management Insights

Management Insights

Monetary Policy Versus Wage Adjustment as a Response to Demand Shocks

One of the central questions in macroeconomic theory is whether aggregate demand shocks are best dealt with by government intervention or by price flexibility. If prices clear the market instantaneously there will be no unemployment problem, while, as shown by Fischer (I977) and Phelps and Taylor (I977), monetary policy can help alleviate unemployment if it is faster to respond to shocks than prices. The case for monetary policy does not, however, rely on it being fast to react relative to prices. As shown by Marini (i986), rational expectations imply that anticipated Government policy can help clear current markets. While rationality of expectations strengthens the case for monetary policy it may weaken the argument for increased price flexibility as a method of dealing with shocks. De Long and Summers (1 986) show that increased price flexibility can lead to an increase in the variance of output in an economy facing demand shocks; the expectation of quick price adjustment exacerbates short-run disequilibrium. This paper examines the effectiveness of price flexibility and monetary policy in a simple model where neither price makers nor the monetary authorities can react instantaneously to shocks. The model is one of overlapping generations, with a single shock. The advantage of such a simple framework is that it clarifies the forces at work and allows direct welfare comparisons between adjustment rules. The first result is that greater price flexibility may decrease welfare, particularly if the effect of expected inflation on demand is non-linear. Slow price adjustment spreads the adjustment cost over many periods, and if demand is concave in expected inflation the aggregate volume of unemployment may be smaller if prices are reduced to their equilibrium level in stages rather than in one jump. Quick monetary policy aimed at full employment is shown to Pareto dominate a slow response. Both give full employment but a slow response requires the imposition of a higher inflation tax. While quick monetary policy is better than a slow response there is a case against instantaneous response to shocks. If full employment is guaranteed costlessly by government the wage and price level become indeterminate. Guaranteeing full employment by means of an inflation tax gives an incentive for wage and price setters to minimise the need for government intervention.

The political economy of guidance planning in Post-Mao China

China adopted modernization as its new development objective in late 1978, many economic reforms have been introduced. Although the reforms cover diverse areas of the economy, the central underlying strategy is to combine economic planning with the market mechanism in order to attain the twin goals of "macro control and micro flexibility." From this strategy, various reform measures logically follow: increased autonomy of the state-owned enterprises to respond to the market, enterprise taxation to replace profit remittances to the state, greater price flexibility, enterprise management reform, etc. A key element of the strategy of combining economic planning with the market mechanism is the concept of what the Chinese call "guidance planning" (zhidao xing jihua). This concept has become so pervasive in Chinese theoretical and policy discussions, and the measures to implement it have become such an integral part of the reform of the economic system that a thorough understanding of it is essential to the understanding of China's economic reforms. This article attempts to shed light on these reforms by studying the Chinese literature on guidance planning and by critically examining the implications and actual implementation of guidance planning.