State-Dependent Pricing and Optimal Monetary Policy

Abstract

This paper analyzes optimal monetary policy under precommitment in a state-dependent pricing (SDP) environment. Under SDP, monopolistically competitive …rms are allowed to endogenously change the timing of price adjustments. I show that this endogenous timing of price adjustment alters the tradeo¤ and the cost of in ‡ation variation faced by the monetary authority in comparison to the standard time-dependent pricing (TDP) assumption. In particular, it is desirable to let in ‡ation vary more under SDP. Despite the change in the policy tradeo¤, however, the optimal response under SDP to either a productivity or a government purchase shock under the timeless perspective (long-run) policy can still be characterized as an approximate price stability rule. Additionally, this paper studies the optimal policy start-up problem related to the cost of adopting the timeless perspective policy instead of the true Ramsey policy. The SDP assumption leads to di¤erent start-up dynamics compared to the dynamics under the TDP assumption in several important ways. In particular, the change in the policy tradeo¤ gives rise to much higher start-up in ‡ation under SDP. JEL Classi…cation: E31, E52, E61

Optimal Monetary Policy with State-Dependent Pricing

“…Our results contrast with recent work by Lie (2009) who also studies optimal monetary policy under state-dependent pricing. Speci…cally, Lie …nds that under state-dependent pricing it is desirable to let in ‡ation vary more than under Calvo pricing.…”

Labor-Market Frictions and Optimal Inflation

“…It is then interesting to study the effect of shutting down the endogenous response of the adjustment probabilities to variations in inflation and let the agents face a fixed adjustment hazard. In contrast to Lie (2010), we find that endogenizing adjustment probabilities matters for the quantitative analysis. Specifically, exogenous price and wage adjustment hazards give a Ramsey optimal inflation rate of 159 percent, thus an increase of almost half a percentage point relative to the case with endogenous adjustment hazards.…”

“…9 The cost distributions   ,   ,   and  follow the beta distribution and are described in appendix A. The parameters for   and  are calibrated following Lie (2010) closely and the parameters for the disagreement cost distributions   and   are chosen to generate a duration of wage contracts of one year; see appendix A for details. For  we use a standard value of 10, generating a markup of around 11 percent.…”

“…Second, because of monopolistic competition and nominal frictions, inflation causes relative price distortions, which drive the optimal inflation rate towards zero. Thus, combining the monetary friction with the nominal price friction, as done by Khan, King, and Wolman (2003), SchmittGrohe Uribe (2004, 2005, 2010 and Lie (2010), yields a negative optimal inflation rate somewhere between the Friedman rule and zero. Finally, we add that some newly hired workers may enter into an existing wage structure, giving rise to the mechanism outlined above.…”

“…Moreover, there are impediments to continuous resetting of nominal prices and wages modeled along the lines of Dotsey, King, and Wolman (1999), where adjustment probabilities are endogenous. Finally, the model features a role for money as a medium of exchange, as in Khan, King, and Wolman (2003) and Lie (2010).…”