Menu Costs, Uncertainty Cycles, and the Propagation of Nominal Shocks
Society for Economic Dynamics Meeting Papers Series 2013, number 663
43 Pages Posted: 17 Oct 2012 Last revised: 27 Jul 2020
Date Written: February 9, 2015
Abstract
Nominal shocks have long lasting effects on real economic activity, beyond those implied by the average frequency of price adjustment in micro data. This paper develops a price-setting model that explains this gap through the interplay of menu costs and uncertainty about productivity. Uncertainty arises from firms' inability to distinguish between permanent and transitory changes in their idiosyncratic productivity. Upon the arrival of a productivity shock, a firm's uncertainty spikes up and then fades with learning until the arrival of the next shock. These uncertainty cycles, when paired with menu costs, generate recurrent episodes of high frequency of price adjustment followed by episodes of low frequency of adjustment at the firm level. This time variation in the individual adjustment frequency is consistent with empirical patterns, in particular a decreasing hazard rate of adjustment, and it is key to understand the sluggish propagation of nominal shocks.
Keywords: Menu costs, uncertainty, learning, monetary policy
JEL Classification: D8, E3, E5
Suggested Citation: Suggested Citation