New Keynesian Macroeconomics...Prof. Dr. Kai Carstensen (LMU Munich) New Keynesian Macroeconomics, Ch. 2 8 / 32. Figure: Price Change Frequency by Product Category Entry Level Items

New Keynesian MacroeconomicsChapter 2: Stylized Microeconomic Facts of the Price Setting Mechanism

Prof. Dr. Kai Carstensen

ifo Institute for Economic Research and LMU Munich

Prof. Dr. Kai Carstensen (LMU Munich) New Keynesian Macroeconomics, Ch. 2 1 / 32

Evidence based on micro price data

Peter J. Klenow and Benjamin A. Malin (2010) Microeconomic

Evidence on Price-Setting, NBER Working Paper No. 15826.


Evidence based on micro price dataData sources

In the last years, large datasets containing detailed quantitative price data underlying CPI or PPIcalculations became available.

Include a large number of monthly price quotes for individual products over several years.

Broadly representative of national consumer expenditures.

Moreover, scanner datasets provide an interesting data source to study price stickiness.

Coverage of a narrower set of goods

However, they provide deeper information (i.e. more items per outlet, information on quantities sold)and are available at higher frequencies (usually weekly)

Recently, attempts have been made to collect price information from retailers’ websites: “Billion PricesProject”. Advantages: daily frequency, large set of countries, detailed item-specific information.


Evidence based on micro price dataFrequency of price changes

Fact 1: Prices change at least once a year.

In the U.S., consumer prices change about every 4 months, while producer prices change every 6-8months. Prices are somewhat stickier in the Euro area (around once a year).

Difficult to match this microdata fact with aggregate outcomes: VAR studies find that monetary shockshave long-lasting real effects.

Hence, nominal stickiness seems insufficient to explain sluggish price adjustment observed in aggregatedata. It is thus usually combined with a “contract multiplier” (Taylor, 1980).

Examples: real rigidities such as strategic complementarities or countercyclical markups, sticky plans andsticky information.



Fact 2: Sales and product turnover are often important for micro flexibility.

Different types of price changes may lead to diverging implications for macro models!

In the U.S.: large price discounts and product turnover make up for about one-third of consumer pricechanges. Sales are however less important in the Euro area.

Sale-related price changes are of a temporary nature and thus partially “cancel out” in the aggregate.

However, in the U.S., sale-related price changes still lead to increased “macro-flexibility” and thus areduced overall degree of nominal stickiness.



Fact 3: Reference prices are stickier and more persistent than regular prices.

Reference price: most often quoted price within a given time period. Thus, Reference price changes areyet another form of price changes next to regular and sale-related price changes.

In U.S. CPI: Many temporary regular price changes but sticky reference prices. On average, referenceprices change every 10-11 months.

Deviations from reference prices do not “cancel out” across items and thus affect aggregate inflation.Reference price inflation is more persistent than regular price inflation.

Thus, reference price changes lead to a more persistent effect of monetary policy, which can be explainedby sticky plan type pricing mechanisms applying for this type of price changes.


Figure: Posted vs. Reference Price Inflation, U.S. CPI

Source: Klenow and Malin, 2010.



Fact 4: There is substantial heterogeneity in the frequency of price changes across goods.

Considerable cross-category heterogeneity: frequency of monthly price change reaches from 2.7%(intracity mass transit) to 91% (regular unleaded gasoline).

Across countries, service prices are stickier than goods prices. Among goods, “raw” goods such asenergy and fresh food are more flexible than processed goods.

In macro models, heterogeneity across goods can be combined with strategic complementarities toincrease the degree of price stickiness and thus generate stronger real effects of monetary policy

Example: firms at different production stages show different degree of price flexibility - price stickinessaccumulates through production chain.


Figure: Price Change Frequency by Product Category

Entry Level Items

Price Ch

ange Frequ

ency


Data are for the top three cities (New York, Los Angeles, and Chicago) January 1988 through October 2009. Each bar corresponds to an ELI product

category (weighted by expenditure), and price change frequency is calculated as the weighted average across quotes within the ELI. Prices include sales

and regular prices.



Fact 5: More cyclical goods change prices more frequently.

One specific form of cross-product heterogeneity: in the U.S. CPI, more frequent price changes areobserved for products with more procyclical real consumption growth.

Examples: transportation (cars, airfares) and apparel.

This relationship may appear because cyclical shocks imply a larger degree of macro price flexibility.

Thus, models that take into account this relationship would predict effects of monetary policy that are lesspronounced relative to models that assume exogenous frequency of price changes.

This is in contrast to the effect of firm-specific sources of heterogeneity (e.g. firm-specific menu cost)which tend to amplify nominal stickiness.


Figure: Frequency vs. Cyclicality in the U.S. CPI

Price Ch

ange Frequ

ency

Cyclicality



Evidence based on micro price dataSize of price changes

Fact 6: Price changes are big on average, but many small changes occur.

Both in the U.S. and in the Euro area, micro price changes are an order of magnitude larger thannecessary to be in line with aggregate inflation. Thus, firm-specific factors are important for price settingrelative to macro shocks.

At the same time, many price changes are small.

Implications for macro models:

Not in line with state-dependent models with a single, large menu cost: “missing middle” in the distributionof price changes in these models.

Time-dependent models à la Taylor or Calvo can match this fact.

However, more complicated menu cost models are also able to reflect this observation (e.g. variable menucosts).


Figure: Distribution of Price Changes

Source: Klenow and Kryvtsov, 2008.


Evidence based on micro price dataDynamic features of price changes

Fact 7: Relative price changes are transitory.

A consequence of large idiosyncratic price changes is that also relative price changes are big. However,these relative price movements are temporary.

This implies that for two goods there is generally a persistent underlying relative price but there might belarge temporary deviations.


Big relative price changes imply: either strategic complementarities are weak or idiosyncratic shocks arelarge. In the former case, the contract multiplier and thus the real effects of monetary policy are small.

Temporary relative price changes may also reflect micro flexibility in a world of macro stickiness. Forexample, if macro shocks are relatively unimportant compared to firm-specific shocks, firms update theirmacro information/macro plan seldom while they often react to the large firm-specific shocks.



Fact 8: Price changes are typically not synchronized over the business cycle.

Example for synchronization: sellers accelerate price increases in response to positive monetary shocksand postpone them following negative monetary shocks. This may lead to reduced real effects ofmonetary policy.

In the U.S. for moderate inflation periods, firms do typically not synchronize price setting. In Germany, thefrequency of price changes seems to react to swings in inflation. In countries with strong changes ininflation levels like Mexico, there is even more synchronization.

Lack of synchronization has implications for macro models:

Consistent with time-dependent models and state-dependent models with large firm-specific shocks.

Evidence in favor of staggered nominal price adjustment. Combination of staggered price adjustment andstrategic complementarities raises the degree of nominal stickiness.


Figure: Retail Price Inflation and Fraction of Price Changing Firms

Source: Carstensen and Schenkelberg, 2011.



Fact 9: Neither frequency nor size is increasing in the age of a price.

In both the U.S. and the Euro area, the hazard rate of price changes is decreasing over the first monthsand is flat afterwards. If sale-related price changes are excluded, the downward slope is reduced.

Relation to theoretical macro literature:

Not in line with intuition of standard state-dependent models: here, the probability of a price changeincreases in time as the distance between actual and optimal price rises.

More complicated menu cost models better able to reflect this fact.

Flat hazard rate accords with predictions of standard time-dependent models (Calvo model).


Figure: Weighted Hazard Rates for Regular Prices, U.S. CPI

Source: Klenow and Kryvtsov, 2008



Fact 10: Price changes are linked to wage changes.

Firms with a relatively high share of labor costs in total costs adjust their prices less frequently.

Possible reason: wages typically adjust less frequently than other input prices due to wage contracts thatare fixed over a certain time period.

Thus, sluggish wage adjustment can contribute to an increased overall degree of nominal stickiness inseveral ways:

Directly, because wages are stickier than prices.

Indirectly by lowering the frequency of price adjustment.

Wage adjustment is largely time-dependent; this pattern could feed through to price adjustment.


Evidence based on firm surveys

S. Fabiani, M. Druant, I. Hernando, C. Kwapil, B. Landau, C. Loupias,F. Martins, T. Mathä, R. Sabbatini, H. Stahl, and A. Stokman (2006)

What Firms’ Surveys Tell Us about Price-Setting Behaviour in the Euro Area,International Journal of Central Banking, September 2006.


Evidence based on firm surveysData sources

Analyzing quantitative price data may not be sufficient to understand determinants of firms’ price settingmechanism. Conducting surveys allows to ask firms directly for their price setting strategies.

Survey data: summary of evidence from surveys conducted in nine Euro area countries in 2003 and 2004.

11 stylized facts emerge from common evidence of these countries.

Advantages of this kind of data source:

Separate assessment of two stages of price setting: price review stage and implementation stage.

Insights concerning information set used in the review of prices.

Possibility to cross-check evidence from quantitative price data.


Evidence based on firm surveysPrice reviews

Fact 1: Both time- and state-dependent pricing strategies are used by Euro area firms.

Around one-third of the companies report that they follow mainly time-dependent rules.

The remaining two-thirds state that they adopt pricing rules with some elements of state-dependence.These firms mainly use a mixed strategy.

This implies that the overall degree of price stickiness in the Euro area is somewhat less pronouncedcompared to predictions of purely time-dependent models.


Evidence based on firm surveysPrice reviews - information set

Fact 2: Around half of the firms review their prices taking into account a wide range of information.

These firms include both past and expected economic developments in their information set; one-third ofthem show a backward-looking behavior.

Important macro implications of the information set used by firms:

The observed pattern accords with recent attempts to estimate hybrid versions of the New KeynesianPhillips curve, which deviate from fully optimizing behavior.

Elements of backward-looking behavior may provide an additional source of stickiness.


Evidence based on firm surveysFrequency of price reviews

Fact 3: In most countries the modal number of price reviews lies in the range of one to three times ayear.

Heterogeneity across sectors: firms in the services sector review prices less frequently than firms in othersectors.

Moreover, in most countries, firms facing high competitive pressure carry out price reviews morefrequently.

Potential reasons for infrequent price reviews:

Possibly sporadic arrival of new information (sticky information).

Costs of price reviews: it may be optimal for firms not to obtain costly information in certain periods(rational inattention).


Evidence based on firm surveysPrice changes

Fact 4: Markup (constant or variable) pricing is the dominant price-setting practice adopted by firms inthe Euro area.

This accords with standard result in models of imperfect competition:

Firms set a price that constitutes a markup over marginal costs. Thus, price rigidities occur because firmsmay choose not to adjust following a cost shock.

However, markup pricing depends on the degree of competition faced by the firms; the prices of around30 percent of firms are shaped by competitors’ prices.


Figure: Markup and Perceived Competition (Percentages)

low competition high competition

Source: Fabiani et al., 2006


Evidence based on firm surveysPrice changes

Fact 5: Price discrimination is common practice for Euro area firms.

Differences across sectors: uniform pricing more common in trade sector, while the degree of pricediscrimination is high in manufacturing.

Fact 6: Competitors’ prices on the foreign market and transportation costs are the most relevant factorsfor pricing-to-market behavior.

Thus, in some countries there are departures from the law of one price.

Even for firms operating outside the Euro area, exchange rate movements are not as important astransportation costs, the price of competitors or cyclical demand fluctuations.


Evidence based on firm surveysFrequency of price changes

Fact 7: The median firm changes its price once a year.

Differences across sectors: nominal stickiness larger in the services sector and less pronounced in thetrade sector.

As in the case of price reviews, degree of competition is an important determinant of frequency of priceadjustment:

In most countries, firms facing strong competitive pressures adjust their prices more frequently.

Remember: average duration of price spells is an important parameter in the calibration of DSGE modelsused for monetary analysis.


Evidence based on firm surveysThe relationship between price reviews and price changes

Fact 8: Price changes are less frequent than price reviews.

Consistent with the idea that price setting takes place in two stages:

Some degree of stickiness already at the first stage of the process when appropriateness of pricesis reviewed.

Once price review has taken place, not always a price change actually occurs.


This fact contrasts implications of sticky information models, where prices change constantly but pricereviews are less frequent.

Moreover, not in line with models assuming lagged inflation indexation, which is another form ofreoptimization constraints faced by firms in any given period.


Evidence based on firm surveysReasons for price stickiness

Fact 9: Implicit and explicit contracts are the most relevant explanations for sticky prices.

This suggests that price rigidities are associated with customers’ preferences for stable nominal prices.

Other relevant factors are related to cost-based pricing and coordination failure. Menu costs do notappear to be very important.

Overall, these results indicate that the main impediments to more-frequent price adjustment areassociated with the price-change stage rather than with the price review stage of the price setting process.


Figure: The Importance of Theories Explaining Price Stickiness

Implicit contracts

Explicit contracts

Cost-based pricing

coordination failure

Judging quality by price

Temporary shocks

Nonprice factors

Menu costs

Costly information

Pricing thresholds

1.2 1.4 1.6 1.8 2.0 2.2 2.4 2.6 2.8

Countries' scores (unweighted average)

Source: based on Fabiani et al., 2006


Evidence based on firm surveysFactors driving price changes

Fact 10: Cost shocks are more relevant in driving prices upward than downward, while shocks to marketconditions matter more for price decreases than increases.

Asymmetric effects of drivers of price changes:

Price increases more often caused by rising input and labor prices as well as financial costs.

Price decreases often due to changes in demand and competitors’ prices.

Fact 11: Firms in highly competitive markets are more likely to respond to changes in underlyingfactors, especially in the case of demand shocks.

Thus, the degree of competition determines the price setting process also with respect to the drivingforces underlying price adjustment.


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New Keynesian Macroeconomics...Prof. Dr. Kai Carstensen (LMU Munich) New Keynesian Macroeconomics, Ch. 2 8 / 32. Figure: Price Change Frequency by Product Category Entry Level Items