Non-Constant Demand Elasticities, Firm Dynamics and Monetary Non-Neutrality: Role of Demand Shocks

Abstract:

We develop a simple menu-cost model with non-constant elasticity of demand that features idiosyncratic productivity and demand shocks. The model is calibrated to match firm-level productivity and demand processes estimated from U.S. data. Despite its simplicity, the calibrated model delivers untargeted pricing dynamics and a markup distribution that are consistent with U.S. micro data. Moreover, it also generates sizable monetary non-neutrality that rivals more complicated alternative menu cost models that explicitly target pricing dynamics. The key in reconciling firm and pricing dynamics comes from the interaction between non-constant elasticity of demand and idiosyncratic demand shocks. Thus, this framework effortlessly unifies pricing, markup, and firm dynamics.