Monetary Policy Obeying the Taylor Principle Turns Prices into Strategic Substitutes

Abstract

Abstract:Monetary policy affects the degree of strategic complementarity in firms' pricing decisions if it responds to the aggregate price level. In normal times, when monopolistic competitive firms increase their prices, the central bank raises interest rates, which lowers consumption demand and creates an incentive for firms to reduce their prices. Thereby, monetary policy reduces the degree of strategic complementarities among firms' pricing decisions and even turns prices into strategic substitutes if the effect of interest rates on demand is sufficiently strong. We show that this condition holds when monetary policy follows the Taylor principle. By contrast, in a liquidity trap where monetary policy is restricted by the zero lower bound, pricing decisions are strategic complements. Our main contribution consists in relating the determinacy and stability of equilibria to strategic substitutability in prices. We discuss the consequences for dynamic adjustment processes and some policy implications. Keywords:monopolistic competition, monetary policy rule, pricing decisions, strategic complementarity, strategic substitutability JEL codes: Our main contribution consists in relating the determinacy and stability of equilibria to strategic substitutability in prices. We discuss the consequences for dynamic adjustment processes and some policy implications.

Learning to Deal With Repeated Shocks Under Strategic Complementarity: An Experiment

“…Cornand and Heinemann (2019) show that in a New Keynesian framework, monetary policy obeying the Taylor principle decreases the degree of complementarity between pricing decisions of firms and even turns them into strategic substitutes if its effect on aggregate demand is sufficiently strong. In a similar vein,Assenza et al (2019) show through their New Keynesian LtFEs that the Taylor principle with sufficiently strong interest rate rule (ξ π = 1.5 in their experiment) manages convergence to the forward stable solution.40Cooper et al (2017) test this argument in an auxiliary treatment and find that the main results are qualitatively unchanged.…”