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Monetary Theory: Price Setting
Behzad Diba
University of Bern
March 2011
(Institute) Monetary Theory: Price Setting March 2011 1 / 10
Notation
Suppose the firm producing intermediate good i , in our setup withmonopolistic competition, sets a price Pt (i), and pays nominaldividends
Dt (i) = Pt (i)Yt (i)−Ψ[Yt (i)]
where Ψ[.] is the firms nominal cost function
Recall that demand for this firm’s output is related to aggregatedemand by
Yt (i) =[Pt (i)Pt
]−ε
Yt
We saw that with flexible prices, the optimal price satisfies
(1− ε) [Pt (i)]−ε (Pt )
ε Yt = −ε [Pt (i)]−ε−1 (Pt )
ε Ytψ[Yt (i)]
where ψ[Yt (i)] ≡ Ψ′[Yt (i)] is nominal marginal cost
(Institute) Monetary Theory: Price Setting March 2011 2 / 10
Notation
Suppose the firm producing intermediate good i , in our setup withmonopolistic competition, sets a price Pt (i), and pays nominaldividends
Dt (i) = Pt (i)Yt (i)−Ψ[Yt (i)]
where Ψ[.] is the firms nominal cost functionRecall that demand for this firm’s output is related to aggregatedemand by
Yt (i) =[Pt (i)Pt
]−ε
Yt
We saw that with flexible prices, the optimal price satisfies
(1− ε) [Pt (i)]−ε (Pt )
ε Yt = −ε [Pt (i)]−ε−1 (Pt )
ε Ytψ[Yt (i)]
where ψ[Yt (i)] ≡ Ψ′[Yt (i)] is nominal marginal cost
(Institute) Monetary Theory: Price Setting March 2011 2 / 10
Notation
Suppose the firm producing intermediate good i , in our setup withmonopolistic competition, sets a price Pt (i), and pays nominaldividends
Dt (i) = Pt (i)Yt (i)−Ψ[Yt (i)]
where Ψ[.] is the firms nominal cost functionRecall that demand for this firm’s output is related to aggregatedemand by
Yt (i) =[Pt (i)Pt
]−ε
Yt
We saw that with flexible prices, the optimal price satisfies
(1− ε) [Pt (i)]−ε (Pt )
ε Yt = −ε [Pt (i)]−ε−1 (Pt )
ε Ytψ[Yt (i)]
where ψ[Yt (i)] ≡ Ψ′[Yt (i)] is nominal marginal cost
(Institute) Monetary Theory: Price Setting March 2011 2 / 10
One-period Price Rigidity
With flexible prices, as we saw, the optimal price is a markup overmarginal cost:
Pt (i) =(
ε
ε− 1
)ψ[Yt (i)]
Now suppose the firm sets Pt+1(i) at date t (there is one-period pricerigidity)Note the role of the markup and next-period’s marginal costIf all firms set their price in this way, a change in aggregate demandwill affect outputAs a casual illustration, consider a binding cash-in-advance (CIA)constraint:
PtCt = Mt
Although one-period price rigidity implies non-neutrality of monetarypolicy, it cannot generate a persistent output response or sluggishprice response for several periods
(Institute) Monetary Theory: Price Setting March 2011 3 / 10
One-period Price Rigidity
With flexible prices, as we saw, the optimal price is a markup overmarginal cost:
Pt (i) =(
ε
ε− 1
)ψ[Yt (i)]
Now suppose the firm sets Pt+1(i) at date t (there is one-period pricerigidity)
Note the role of the markup and next-period’s marginal costIf all firms set their price in this way, a change in aggregate demandwill affect outputAs a casual illustration, consider a binding cash-in-advance (CIA)constraint:
PtCt = Mt
Although one-period price rigidity implies non-neutrality of monetarypolicy, it cannot generate a persistent output response or sluggishprice response for several periods
(Institute) Monetary Theory: Price Setting March 2011 3 / 10
The firm sets Pt+1(i) to maximize
βEt
[(Λt+1Λt
){Pt+1(i)Yt+1(i)−Ψ[Yt+1(i)]}
]subject to
Yt+1(i) =
[Pt+1(i)
Pt+1
]−εYt+1
The FOC is
βEt
[(Λt+1Λt
){(1− ε) [Pt+1(i)]
−ε(Pt+1)
εYt+1 + ε [Pt+1(i)]
−ε−1(Pt+1)
εYt+1ψ[Yt+1(i)]
}]= 0
Multiply this by Pt+1(i) (which is not random at date t) and divide by (1− ε)to get
Et
[(Λt+1Λt
){Pt+1(i)Yt+1(i)−
(ε
ε− 1
)Yt+1(i)ψ[Yt+1(i)]
}]= 0
and
Pt+1(i) =
(ε
ε− 1
)Et {Λt+1Yt+1(i)ψ[Yt+1(i)]}
Et [Λt+1Yt+1(i)]
1
One-period Price Rigidity
With flexible prices, as we saw, the optimal price is a markup overmarginal cost:
Pt (i) =(
ε
ε− 1
)ψ[Yt (i)]
Now suppose the firm sets Pt+1(i) at date t (there is one-period pricerigidity)Note the role of the markup and next-period’s marginal cost
If all firms set their price in this way, a change in aggregate demandwill affect outputAs a casual illustration, consider a binding cash-in-advance (CIA)constraint:
PtCt = Mt
Although one-period price rigidity implies non-neutrality of monetarypolicy, it cannot generate a persistent output response or sluggishprice response for several periods
(Institute) Monetary Theory: Price Setting March 2011 3 / 10
One-period Price Rigidity
With flexible prices, as we saw, the optimal price is a markup overmarginal cost:
Pt (i) =(
ε
ε− 1
)ψ[Yt (i)]
Now suppose the firm sets Pt+1(i) at date t (there is one-period pricerigidity)Note the role of the markup and next-period’s marginal costIf all firms set their price in this way, a change in aggregate demandwill affect output
As a casual illustration, consider a binding cash-in-advance (CIA)constraint:
PtCt = Mt
Although one-period price rigidity implies non-neutrality of monetarypolicy, it cannot generate a persistent output response or sluggishprice response for several periods
(Institute) Monetary Theory: Price Setting March 2011 3 / 10
One-period Price Rigidity
With flexible prices, as we saw, the optimal price is a markup overmarginal cost:
Pt (i) =(
ε
ε− 1
)ψ[Yt (i)]
Now suppose the firm sets Pt+1(i) at date t (there is one-period pricerigidity)Note the role of the markup and next-period’s marginal costIf all firms set their price in this way, a change in aggregate demandwill affect outputAs a casual illustration, consider a binding cash-in-advance (CIA)constraint:
PtCt = Mt
Although one-period price rigidity implies non-neutrality of monetarypolicy, it cannot generate a persistent output response or sluggishprice response for several periods
(Institute) Monetary Theory: Price Setting March 2011 3 / 10
One-period Price Rigidity
With flexible prices, as we saw, the optimal price is a markup overmarginal cost:
Pt (i) =(
ε
ε− 1
)ψ[Yt (i)]
Now suppose the firm sets Pt+1(i) at date t (there is one-period pricerigidity)Note the role of the markup and next-period’s marginal costIf all firms set their price in this way, a change in aggregate demandwill affect outputAs a casual illustration, consider a binding cash-in-advance (CIA)constraint:
PtCt = Mt
Although one-period price rigidity implies non-neutrality of monetarypolicy, it cannot generate a persistent output response or sluggishprice response for several periods
(Institute) Monetary Theory: Price Setting March 2011 3 / 10
Two-period Price Rigidity
Consider next a firm setting the same price for two periods at date t
The optimal price depends on marginal cost at t and the expectationof marginal cost at t + 1
In the steady-state equilibrium with zero inflation , Λt is constant
In the neighborhood of a zero-inflation steady state, we get
p̂t (i) =(
11+ β
)ψ̂t (i) +
(β
1+ β
)Et ψ̂t+1(i)
linking the price deviation to a weighted average of the currentmarginal-cost deviation and the current expectation of next-period’smarginal-cost deviation
(Institute) Monetary Theory: Price Setting March 2011 4 / 10
The firm sets Pt(i) to maximize
Pt(i)Yt(i)−Ψ[Yt(i)] + βEt
[(Λt+1Λt
){Pt(i)Yt+1(i)−Ψ[Yt+1(i)]}
]subject to
Yt(i) =
[Pt(i)
Pt
]−εYt
and
Yt+1(i) =
[Pt(i)
Pt+1
]−εYt+1
The FOC is
0 = (1− ε) [Pt(i)]−ε
(Pt)εYt + ε [Pt(i)]
−ε−1(Pt)
εYtψ[Yt(i)]
+βEt
[(Λt+1Λt
){(1− ε) [Pt(i)]
−ε(Pt+1)
εYt+1 + ε [Pt(i)]
−ε−1(Pt+1)
εYt+1ψ[Yt+1(i)]
}]Multiply this by Pt(i) and divide by (1− ε) to get
0 = Pt(i)Yt(i)−(
ε
ε− 1
)Yt(i)ψ[Yt(i)]
+βEt
[(Λt+1Λt
){Pt(i)Yt+1(i)−
(ε
ε− 1
)Yt+1(i)ψ[Yt+1(i)]
}]Or
1∑k=0
βkEt
[(Λt+kΛt
)Yt+k(i)
{Pt(i)−
(ε
ε− 1
)ψ[Yt+k(i)]
}]= 0
1
Two-period Price Rigidity
Consider next a firm setting the same price for two periods at date t
The optimal price depends on marginal cost at t and the expectationof marginal cost at t + 1
In the steady-state equilibrium with zero inflation , Λt is constant
In the neighborhood of a zero-inflation steady state, we get
p̂t (i) =(
11+ β
)ψ̂t (i) +
(β
1+ β
)Et ψ̂t+1(i)
linking the price deviation to a weighted average of the currentmarginal-cost deviation and the current expectation of next-period’smarginal-cost deviation
(Institute) Monetary Theory: Price Setting March 2011 4 / 10
Two-period Price Rigidity
Consider next a firm setting the same price for two periods at date t
The optimal price depends on marginal cost at t and the expectationof marginal cost at t + 1
In the steady-state equilibrium with zero inflation , Λt is constant
In the neighborhood of a zero-inflation steady state, we get
p̂t (i) =(
11+ β
)ψ̂t (i) +
(β
1+ β
)Et ψ̂t+1(i)
linking the price deviation to a weighted average of the currentmarginal-cost deviation and the current expectation of next-period’smarginal-cost deviation
(Institute) Monetary Theory: Price Setting March 2011 4 / 10
Two-period Price Rigidity
Consider next a firm setting the same price for two periods at date t
The optimal price depends on marginal cost at t and the expectationof marginal cost at t + 1
In the steady-state equilibrium with zero inflation , Λt is constant
In the neighborhood of a zero-inflation steady state, we get
p̂t (i) =(
11+ β
)ψ̂t (i) +
(β
1+ β
)Et ψ̂t+1(i)
linking the price deviation to a weighted average of the currentmarginal-cost deviation and the current expectation of next-period’smarginal-cost deviation
(Institute) Monetary Theory: Price Setting March 2011 4 / 10
2 Approximation
In a steady-state equilibrium with zero inflation, we have
P (i)Y (i) (1 + β) =
(ε
ε− 1
)ψ(i)Y (i) (1 + β)
(implying that price is a markup over nominal marginal cost; and real marginalcost is the inverse of the markup)Approximating
Pt(i)
[Yt(i) + βEt
(Λt+1Λt
)Yt+1(i)
]=
(ε
ε− 1
){Yt(i)ψt(i) + βEt
(Λt+1Λt
)Yt+1(i)ψt+1(i)]
}near this state, we get
Y (i)(1+β) [Pt(i)− P (i)] =
(ε
ε− 1
){Y (i)[ψt(i)− ψ(i)] + βY (i)Et[ψt+1(i)− ψ(i)]
}and
p̂t(i) =
(1
1 + β
)ψ̂t(i) +
(β
1 + β
)Et ̂ψt+1(i)
2
Staggered Price Setting
Taylor’s survey (summarized in Chapter 1) and subsequent work
Two-period Taylor contracts: half the firms set a new price P∗t andthe other half keep the price P∗t−1 that they had set last period
The aggregate price level Pt follows
Pt =
1∫0
[Pt (i)]1−ε di
11−ε
=
{12(P∗t−1)
1−ε +12(P∗t )
1−ε
} 11−ε
In the neighborhood of a zero-inflation steady state
p̂t =12p̂∗t−1 +
12p̂∗t
Multi-period Taylor contracts
Calvo contracts (discussed below)
(Institute) Monetary Theory: Price Setting March 2011 5 / 10
Staggered Price Setting
Taylor’s survey (summarized in Chapter 1) and subsequent work
Two-period Taylor contracts: half the firms set a new price P∗t andthe other half keep the price P∗t−1 that they had set last period
The aggregate price level Pt follows
Pt =
1∫0
[Pt (i)]1−ε di
11−ε
=
{12(P∗t−1)
1−ε +12(P∗t )
1−ε
} 11−ε
In the neighborhood of a zero-inflation steady state
p̂t =12p̂∗t−1 +
12p̂∗t
Multi-period Taylor contracts
Calvo contracts (discussed below)
(Institute) Monetary Theory: Price Setting March 2011 5 / 10
Staggered Price Setting
Taylor’s survey (summarized in Chapter 1) and subsequent work
Two-period Taylor contracts: half the firms set a new price P∗t andthe other half keep the price P∗t−1 that they had set last period
The aggregate price level Pt follows
Pt =
1∫0
[Pt (i)]1−ε di
11−ε
=
{12(P∗t−1)
1−ε +12(P∗t )
1−ε
} 11−ε
In the neighborhood of a zero-inflation steady state
p̂t =12p̂∗t−1 +
12p̂∗t
Multi-period Taylor contracts
Calvo contracts (discussed below)
(Institute) Monetary Theory: Price Setting March 2011 5 / 10
Staggered Price Setting
Taylor’s survey (summarized in Chapter 1) and subsequent work
Two-period Taylor contracts: half the firms set a new price P∗t andthe other half keep the price P∗t−1 that they had set last period
The aggregate price level Pt follows
Pt =
1∫0
[Pt (i)]1−ε di
11−ε
=
{12(P∗t−1)
1−ε +12(P∗t )
1−ε
} 11−ε
In the neighborhood of a zero-inflation steady state
p̂t =12p̂∗t−1 +
12p̂∗t
Multi-period Taylor contracts
Calvo contracts (discussed below)
(Institute) Monetary Theory: Price Setting March 2011 5 / 10
Let P ∗t denote the new price set at t and
(Pt)1−ε
=1
2(P ∗t−1)
1−ε +1
2(P ∗t )1−ε
In a deterministic steady state with zero inflation, we have P = P ∗, and nearthat steady state,
(1− ε) (P )−ε
(Pt − P ) ∼= (1− ε) (P ∗)−ε[
1
2(P ∗t−1 − P ∗) +
1
2(P ∗t − P ∗)
],
andp̂t =
1
2p̂∗t−1 +
1
2p̂∗t
3
Staggered Price Setting
Taylor’s survey (summarized in Chapter 1) and subsequent work
Two-period Taylor contracts: half the firms set a new price P∗t andthe other half keep the price P∗t−1 that they had set last period
The aggregate price level Pt follows
Pt =
1∫0
[Pt (i)]1−ε di
11−ε
=
{12(P∗t−1)
1−ε +12(P∗t )
1−ε
} 11−ε
In the neighborhood of a zero-inflation steady state
p̂t =12p̂∗t−1 +
12p̂∗t
Multi-period Taylor contracts
Calvo contracts (discussed below)
(Institute) Monetary Theory: Price Setting March 2011 5 / 10
Staggered Price Setting
Taylor’s survey (summarized in Chapter 1) and subsequent work
Two-period Taylor contracts: half the firms set a new price P∗t andthe other half keep the price P∗t−1 that they had set last period
The aggregate price level Pt follows
Pt =
1∫0
[Pt (i)]1−ε di
11−ε
=
{12(P∗t−1)
1−ε +12(P∗t )
1−ε
} 11−ε
In the neighborhood of a zero-inflation steady state
p̂t =12p̂∗t−1 +
12p̂∗t
Multi-period Taylor contracts
Calvo contracts (discussed below)
(Institute) Monetary Theory: Price Setting March 2011 5 / 10
Calvo’s Model
A tractable way to model staggered price (or wage) setting with anyaverage duration
In each period, each firm gets to reset its price with a constantprobability (1− θ), regardless of when the current price was set
Focusing on a symmetric equilibrium, all the firms that get to set anew price at time t, choose the same price P∗tThe evolution of the aggregate price level is governed by
Pt =
1∫0
[Pt (i)]1−ε di
11−ε
={
θ(Pt−1)1−ε + (1− θ)(P∗t )1−ε} 11−ε
(Institute) Monetary Theory: Price Setting March 2011 6 / 10
Calvo’s Model
A tractable way to model staggered price (or wage) setting with anyaverage duration
In each period, each firm gets to reset its price with a constantprobability (1− θ), regardless of when the current price was set
Focusing on a symmetric equilibrium, all the firms that get to set anew price at time t, choose the same price P∗tThe evolution of the aggregate price level is governed by
Pt =
1∫0
[Pt (i)]1−ε di
11−ε
={
θ(Pt−1)1−ε + (1− θ)(P∗t )1−ε} 11−ε
(Institute) Monetary Theory: Price Setting March 2011 6 / 10
Firms
� Continuum of �rms, indexed by i 2 [0; 1]� Each �rm produces a di¤erentiated good� Identical technology
Yt(i) = At Nt(i)1��
� Probability of resetting price in any given period: 1 � �, independentacross �rms (Calvo (1983)).
� � 2 [0; 1] : index of price stickiness� Implied average price duration 1
1��
Calvo’s Model
A tractable way to model staggered price (or wage) setting with anyaverage duration
In each period, each firm gets to reset its price with a constantprobability (1− θ), regardless of when the current price was set
Focusing on a symmetric equilibrium, all the firms that get to set anew price at time t, choose the same price P∗t
The evolution of the aggregate price level is governed by
Pt =
1∫0
[Pt (i)]1−ε di
11−ε
={
θ(Pt−1)1−ε + (1− θ)(P∗t )1−ε} 11−ε
(Institute) Monetary Theory: Price Setting March 2011 6 / 10
Optimal Price Setting
maxP �t
1Xk=0
�k Et
�Qt;t+k
�P �t Yt+kjt � t+k(Yt+kjt)
�subject to
Yt+kjt = (P�t =Pt+k)
�� Ct+k
for k = 0; 1; 2; :::where
Qt;t+k � �k�Ct+kCt
����PtPt+k
�
Optimality condition:1Xk=0
�k Et
�Qt;t+k Yt+kjt
�P �t �M t+kjt
�= 0
where t+kjt � 0t+k(Yt+kjt) andM� ���1
Calvo’s Model
A tractable way to model staggered price (or wage) setting with anyaverage duration
In each period, each firm gets to reset its price with a constantprobability (1− θ), regardless of when the current price was set
Focusing on a symmetric equilibrium, all the firms that get to set anew price at time t, choose the same price P∗tThe evolution of the aggregate price level is governed by
Pt =
1∫0
[Pt (i)]1−ε di
11−ε
={
θ(Pt−1)1−ε + (1− θ)(P∗t )1−ε} 11−ε
(Institute) Monetary Theory: Price Setting March 2011 6 / 10
Evolution of Calvo Prices
In a deterministic steady state with zero inflation,
(Pt )1−ε = θ(Pt−1)1−ε + (1− θ)(P∗t )
1−ε
implies P = P∗, and we get
(1− ε) (P)−ε (Pt − P) ∼= (1− ε) (P)−ε [θ(Pt−1 − P)+(1− θ)(P∗t − P∗)]
andp̂t ∼= θp̂t−1 + (1− θ)p̂∗t
So the inflation deviations (from the steady-state value of zero) satisfy
π̂t ≡ p̂t − p̂t−1 ∼= (1− θ)(p̂∗t − p̂t−1)
(Institute) Monetary Theory: Price Setting March 2011 7 / 11
Evolution of Calvo Prices
In a deterministic steady state with zero inflation,
(Pt )1−ε = θ(Pt−1)1−ε + (1− θ)(P∗t )
1−ε
implies P = P∗, and we get
(1− ε) (P)−ε (Pt − P) ∼= (1− ε) (P)−ε [θ(Pt−1 − P)+(1− θ)(P∗t − P∗)]
andp̂t ∼= θp̂t−1 + (1− θ)p̂∗t
So the inflation deviations (from the steady-state value of zero) satisfy
π̂t ≡ p̂t − p̂t−1 ∼= (1− θ)(p̂∗t − p̂t−1)
(Institute) Monetary Theory: Price Setting March 2011 7 / 11
Aggregate Price Dynamics
Pt =�� (Pt�1)
1�� + (1� �) (P �t )1��� 1
1��
Dividing by Pt�1 :
�1��t = � + (1� �)
�P �tPt�1
�1��
Log-linearization around zero in�ation steady state
�t = (1� �) (p�t � pt�1) (1)
or, equivalentlypt = � pt�1 + (1� �) p�t
Implications of Staggered Price Setting
Cutting the nominal interest rate lowers the expected real interestrate and increases aggregate demand
With our iso-elastic utility function, this relationship is
ct ∼= Et [ct+1]−1σ[it − Et (πt+1)− ρ]
Some firms react to an increase in aggregate demand by raising prices
Other firms (with rigid prices) end up increasing production
The difference in responses across firms raises interesting normativequestions (discussed in Chapter 4)
(Institute) Monetary Theory: Price Setting March 2011 8 / 10
Implications of Staggered Price Setting
Cutting the nominal interest rate lowers the expected real interestrate and increases aggregate demand
With our iso-elastic utility function, this relationship is
ct ∼= Et [ct+1]−1σ[it − Et (πt+1)− ρ]
Some firms react to an increase in aggregate demand by raising prices
Other firms (with rigid prices) end up increasing production
The difference in responses across firms raises interesting normativequestions (discussed in Chapter 4)
(Institute) Monetary Theory: Price Setting March 2011 8 / 10
Implications of Staggered Price Setting
Cutting the nominal interest rate lowers the expected real interestrate and increases aggregate demand
With our iso-elastic utility function, this relationship is
ct ∼= Et [ct+1]−1σ[it − Et (πt+1)− ρ]
Some firms react to an increase in aggregate demand by raising prices
Other firms (with rigid prices) end up increasing production
The difference in responses across firms raises interesting normativequestions (discussed in Chapter 4)
(Institute) Monetary Theory: Price Setting March 2011 8 / 10
Implications of Staggered Price Setting
Cutting the nominal interest rate lowers the expected real interestrate and increases aggregate demand
With our iso-elastic utility function, this relationship is
ct ∼= Et [ct+1]−1σ[it − Et (πt+1)− ρ]
Some firms react to an increase in aggregate demand by raising prices
Other firms (with rigid prices) end up increasing production
The difference in responses across firms raises interesting normativequestions (discussed in Chapter 4)
(Institute) Monetary Theory: Price Setting March 2011 8 / 10
Implications of Staggered Price Setting
Cutting the nominal interest rate lowers the expected real interestrate and increases aggregate demand
With our iso-elastic utility function, this relationship is
ct ∼= Et [ct+1]−1σ[it − Et (πt+1)− ρ]
Some firms react to an increase in aggregate demand by raising prices
Other firms (with rigid prices) end up increasing production
The difference in responses across firms raises interesting normativequestions (discussed in Chapter 4)
(Institute) Monetary Theory: Price Setting March 2011 8 / 10
Price Setting in Calvo’s Model
Firms that get to set a new price at time t set it to maximize theexpect present value of profits over all future states in which this priceprevails
Note the similarities (and differences) with the FOC for our 2-periodprice setting problem:
1
∑k=0
βkEt
[(Λt+k
Λt
)Yt+k (i)
{Pt (i)−
(ε
ε− 1
)ψ[Yt+k (i)]
}]= 0
The link between new prices and real marginal cost
(Institute) Monetary Theory: Price Setting March 2011 9 / 10
Optimal Price Setting
maxP �t
1Xk=0
�k Et
�Qt;t+k
�P �t Yt+kjt � t+k(Yt+kjt)
�subject to
Yt+kjt = (P�t =Pt+k)
�� Ct+k
for k = 0; 1; 2; :::where
Qt;t+k � �k�Ct+kCt
����PtPt+k
�
Optimality condition:1Xk=0
�k Et
�Qt;t+k Yt+kjt
�P �t �M t+kjt
�= 0
where t+kjt � 0t+k(Yt+kjt) andM� ���1
Price Setting in Calvo’s Model
Firms that get to set a new price at time t set it to maximize theexpect present value of profits over all future states in which this priceprevails
Note the similarities (and differences) with the FOC for our 2-periodprice setting problem:
1
∑k=0
βkEt
[(Λt+k
Λt
)Yt+k (i)
{Pt (i)−
(ε
ε− 1
)ψ[Yt+k (i)]
}]= 0
The link between new prices and real marginal cost
(Institute) Monetary Theory: Price Setting March 2011 9 / 10
Price Setting in Calvo’s Model
Firms that get to set a new price at time t set it to maximize theexpect present value of profits over all future states in which this priceprevails
Note the similarities (and differences) with the FOC for our 2-periodprice setting problem:
1
∑k=0
βkEt
[(Λt+k
Λt
)Yt+k (i)
{Pt (i)−
(ε
ε− 1
)ψ[Yt+k (i)]
}]= 0
The link between new prices and real marginal cost
(Institute) Monetary Theory: Price Setting March 2011 9 / 10
Equivalently,1Xk=0
�k Et
�Qt;t+k Yt+kjt
�P �tPt�1
�M MCt+kjt �t�1;t+k
��= 0
where MCt+kjt � t+kjt=Pt+k and �t�1;t+k � Pt+k=Pt�1
Perfect Foresight, Zero In�ation Steady State:
P �tPt�1
= 1 ; �t�1;t+k = 1 ; Yt+kjt = Y ; Qt;t+k = �k ; MC =1
M
Log-linearization around zero in�ation steady state:
p�t � pt�1 = (1� ��)
1Xk=0
(��)k Etfcmct+kjt + pt+k � pt�1g
where cmct+kjt � mct+kjt �mc.
Equivalently,
p�t = � + (1� ��)1Xk=0
(��)k Etfmct+kjt + pt+kg
where � � log ���1.
Flexible prices (� = 0):p�t = � +mct + pt
=) mct = �� (symmetric equilibrium)
Inflation Dynamics in Calvo’s Model
With a linear production function (α = 0), all the firms have the samemarginal cost
In this case, real marginal cost equals
Wt
PtAt
and an increase in aggregate demand increases real marginal cost byincreasing the real wage
With diminishing returns to labor (0 < α < 1), firms with differentprices have different marginal costs; but aggregation across firms isfacilitated by the Calvo structure
In this case, an increase in aggregate demand increases real marginalcost through two channels: by increasing the real wage and reducingthe marginal product of labor
(Institute) Monetary Theory: Price Setting March 2011 10 / 10
Particular Case: � = 0 (constant returns)
=) MCt+kjt =MCt+k
Rewriting the optimal price setting rule in recursive form:
p�t = �� Etfp�t+1g + (1� ��) cmct + (1� ��)pt (2)
Combining (1) and (2):
�t = � Etf�t+1g + � cmctwhere
� � (1� �)(1� ��)
�
Inflation Dynamics in Calvo’s Model
With a linear production function (α = 0), all the firms have the samemarginal cost
In this case, real marginal cost equals
Wt
PtAt
and an increase in aggregate demand increases real marginal cost byincreasing the real wage
With diminishing returns to labor (0 < α < 1), firms with differentprices have different marginal costs; but aggregation across firms isfacilitated by the Calvo structure
In this case, an increase in aggregate demand increases real marginalcost through two channels: by increasing the real wage and reducingthe marginal product of labor
(Institute) Monetary Theory: Price Setting March 2011 10 / 10
Inflation Dynamics in Calvo’s Model
With a linear production function (α = 0), all the firms have the samemarginal cost
In this case, real marginal cost equals
Wt
PtAt
and an increase in aggregate demand increases real marginal cost byincreasing the real wage
With diminishing returns to labor (0 < α < 1), firms with differentprices have different marginal costs; but aggregation across firms isfacilitated by the Calvo structure
In this case, an increase in aggregate demand increases real marginalcost through two channels: by increasing the real wage and reducingthe marginal product of labor
(Institute) Monetary Theory: Price Setting March 2011 10 / 10
Generalization to � 2 (0; 1) (decreasing returns)De�ne
mct � (wt � pt)�mpnt
� (wt � pt)�1
1� �(at � �yt)� log(1� �)
Using mct+kjt = (wt+k � pt+k)� 11�� (at+k � �yt+kjt)� log(1� �),
mct+kjt = mct+k +�
1� �(yt+kjt � yt+k)
= mct+k ���
1� �(p�t � pt+k) (3)
Implied in�ation dynamics
�t = � Etf�t+1g + � cmct (4)
where
� � (1� �)(1� ��)
�
1� �
1� � + ��
Inflation Dynamics in Calvo’s Model
With a linear production function (α = 0), all the firms have the samemarginal cost
In this case, real marginal cost equals
Wt
PtAt
and an increase in aggregate demand increases real marginal cost byincreasing the real wage
With diminishing returns to labor (0 < α < 1), firms with differentprices have different marginal costs; but aggregation across firms isfacilitated by the Calvo structure
In this case, an increase in aggregate demand increases real marginalcost through two channels: by increasing the real wage and reducingthe marginal product of labor
(Institute) Monetary Theory: Price Setting March 2011 10 / 10
Real Marginal Cost and Inflation Dynamics in Calvo’sModel
An increase in real marginal cost increases inflation because it erodesthe monopoly markup
To protect their markups, firms setting new prices choose a higherprice, which leads to inflation
The response coeffi cient λ in
πt = βEtπt+1 + λm̂c t
is inversely related to the degree of price rigidity θ
Iterating forward,the bounded solution for inflation is
πt = λEt∞
∑j=0
βj m̂c t+j
(Institute) Monetary Theory: Price Setting March 2011 11 / 11
Real Marginal Cost and Inflation Dynamics in Calvo’sModel
An increase in real marginal cost increases inflation because it erodesthe monopoly markup
To protect their markups, firms setting new prices choose a higherprice, which leads to inflation
The response coeffi cient λ in
πt = βEtπt+1 + λm̂c t
is inversely related to the degree of price rigidity θ
Iterating forward,the bounded solution for inflation is
πt = λEt∞
∑j=0
βj m̂c t+j
(Institute) Monetary Theory: Price Setting March 2011 11 / 11
Real Marginal Cost and Inflation Dynamics in Calvo’sModel
An increase in real marginal cost increases inflation because it erodesthe monopoly markup
To protect their markups, firms setting new prices choose a higherprice, which leads to inflation
The response coeffi cient λ in
πt = βEtπt+1 + λm̂c t
is inversely related to the degree of price rigidity θ
Iterating forward,the bounded solution for inflation is
πt = λEt∞
∑j=0
βj m̂c t+j
(Institute) Monetary Theory: Price Setting March 2011 11 / 11
Real Marginal Cost and Inflation Dynamics in Calvo’sModel
An increase in real marginal cost increases inflation because it erodesthe monopoly markup
To protect their markups, firms setting new prices choose a higherprice, which leads to inflation
The response coeffi cient λ in
πt = βEtπt+1 + λm̂c t
is inversely related to the degree of price rigidity θ
Iterating forward,the bounded solution for inflation is
πt = λEt∞
∑j=0
βj m̂c t+j
(Institute) Monetary Theory: Price Setting March 2011 11 / 11
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