Price plans and the real effects of monetary policy

Abstract:

Transitory price changes are prominent in the data but do not fit neatly in standard sticky price models. We present a model where a firm chooses a “price plan”, namely a set of 2 prices each of which can be freely posted at each moment. While price changes between prices within the plan are free, the plan can be changed only subject to a fixed menu cost. This setup generates a persistent “reference”
price level and short lived deviations from it, as seen in many datasets. The model also produces a decreasing hazard function for price changes, a feature that appears in several datasets. We analytically solve for the optimal policy of a firm, and for the cumulative impulse response function of output to a once and for all monetary shock. We compare the economy with the 2-price plan to a menu-cost economy (i.e. a plan with 1 price) featuring the same number of persistent price changes. We show that, for a small monetary shock, the introduction of a plan with 2 prices yields a cumulative output response that is 1/3 of the one produced by the menu cost economy. The smaller real effect of the monetary shock is due to the flexibility delivered by the temporary price changes which are used by the firms to respond to the aggregate shock.