Precautionary Price Stickiness

46 Pages Posted: 25 Aug 2011

See all articles by James S. Costain

James S. Costain

Banco de España - Research Department

Anton Nakov

European Central Bank (ECB); CEPR

Multiple version iconThere are 3 versions of this paper

Date Written: August 19, 2011

Abstract

This paper proposes two models in which price stickiness arises endogenously even though firms are free to change their prices at zero physical cost. Firms are subject to idiosyncratic and aggregate shocks, and they also face a risk of making errors when they set their prices. In our first specification, firms are assumed to play a dynamic logit equilibrium, which implies that big mistakes are less likely than small ones. The second specification derives logit behavior from an assumption that precision is costly. The empirical implications of the two versions of our model are very similar. Since firms making sufficiently large errors choose to adjust, both versions generate a strong "selection effect" in response to a nominal shock that eliminates most of the monetary non-neutrality found in the Calvo model. Thus the model implies that money shocks have little impact on the real economy, as in Golosov and Lucas (2007), but fits microdata better than their specification.

Keywords: Logit equilibrium, state-dependent pricing, (S,s) adjustment, near rationality, information-constrained pricing

JEL Classification: E31, D81, C72

Suggested Citation

Costain, James S. and Nakov, Anton A., Precautionary Price Stickiness (August 19, 2011). ECB Working Paper No. 1375, Available at SSRN: https://ssrn.com/abstract=1912484 or http://dx.doi.org/10.2139/ssrn.1912484

James S. Costain (Contact Author)

Banco de España - Research Department ( email )

Alcala 50
28014 Madrid
Spain

Anton A. Nakov

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

CEPR ( email )

London
United Kingdom

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