Cross-Sectional Inflation Risk in Menu Cost Models with Heterogeneous Firms
38 Pages Posted: 9 Nov 2013
Date Written: December 14, 2012
We show that firms in models with menu costs, when calibrated to have the empirically observed frequency and size of individual-goods price adjustments, have stock returns that are always positively correlated with inflation. The cross-sectional dispersion in this correlation is almost negligible, even though firms have very diverse micro-level pricing behavior. Because in this class of models positive nominal shocks are good states of nature and the correlation between stock returns and inflation is positive, agents are willing to pay a premium to hold assets whose returns covary negatively with inflation. In contrast, we empirically find that the dispersion in the correlation between stock returns and inflation is about 100 times larger than in the model, and that correlations are negative about half the time. Furthermore, and also at odds with sticky-price models, investors require a premium to hedge against states of high inflation. Because firms’ heterogeneity is the key mechanism that generates a high degree of monetary non-neutrality in the models, our results suggest that we do not yet have a full account of the monetary transmission mechanism, and that asset prices can provide important information about it.
Keywords: inflation, menu costs, new Keynesian, DSGE, cross-section, asset prices, stock returns
JEL Classification: E30, E31, E44, E52, G10, G11, G12
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