RDP 9502: Price Stickiness and Inflation 1. Introduction

The idea that nominal prices and wages are sticky was one of the foundation-stones upon which the discipline of macroeconomics was built. This stickiness of prices and wages is of more than idle concern – it has crucial implications for the behaviour of the macroeconomy. It implies, for example, that in the short-run, monetary policy changes affect economic activity rather than prices.

It is usually argued that price and wage stickiness is asymmetric, with prices and wages being more flexible when going up than when going down (see, for example, James Tobin in his Presidential Address to the American Economic Society, 1972). Rather than deriving the asymmetry of price and wage stickiness from microeconomics, however, it has been traditional instead to simply assume it, arguing that it arises from social customs, or perhaps from notions of fairness (Kahneman et al., 1986).

In contrast with this traditional approach, modern New Keynesian theories assume that firms' pricing behaviour can be derived from microeconomic first principles. These theories assume the existence of a small “menu” cost associated with changing a price. Faced with this menu cost, it is sometimes optimal for a firm to leave its output price unchanged, when in a frictionless world, the firm would change price. Nominal price stickiness then emerges as a natural consequence of the optimising behaviour of price-setting firms. These theories assume there is nothing special about price falls, as opposed to price rises. Price changes in either direction are instead simply a consequence of firms' microeconomic environment and the shocks they face.

This paper provides empirical evidence to help distinguish between these two competing explanations for price stickiness. (The paper does not, however, provide any evidence about wage stickiness.) We use a twenty-year sample of Australian industry prices and a forty-year sample of US industry prices to examine two aspects of price stickiness.

First, we use the Australian data to address the question: do firms appear to have any special aversion to price falls? In each period (a quarter or a year) we compare the proportion of industries experiencing a price fall with the proportion experiencing a price rise greater than twice the economy-wide average inflation rate over the period. If there is nothing special about price falls, the proportion of price falls should not be systematically smaller than the proportion of price rises greater than twice the inflation rate. Examining both quarterly and annual data, this is indeed the result we find. By this measure, firms do not show any special reluctance to lower their prices.

The paper's main focus, however, is on a second aspect of price stickiness. We examine the implications of a recent New Keynesian model of firm price-setting behaviour developed by Ball and Mankiw (1992a, b) which established novel implications for the relationship between the economy-wide distribution of shocks and the inflation rate.^[1]

Our main contribution is to demonstrate the importance of expected inflation for this story. We show that the Ball-Mankiw model has a rich set of implications for the links between expected inflation, the economy-wide distribution of relative-price shocks and actual inflation. When expected inflation is very low, the model implies that a rise in the dispersion of shocks has minimal impact on actual inflation while a rise in the skewness of shocks is inflationary. When expected inflation is higher, however, a rise in either the dispersion or skewness of shocks is inflationary.

As we show, the empirical evidence from industry price data strongly supports these detailed implications, both at different rates of expected inflation and in two industrial economies, Australia and the United States. This confirms and strengthens the argument that the aggregate implications of price stickiness can be understood in terms of the optimising behaviour of firms with market power responding to the shocks they face. It increases our confidence in our understanding of the microeconomics of firm pricing behaviour and its implications for aggregate inflation.

The paper is organised as follows. The next section discusses our sample of Australian industry price data and examines these data for evidence that firms have an aversion to price falls. Section 3 outlines the Ball-Mankiw model and derives its implications for the relationship between expected inflation, the economy-wide distribution of shocks and the inflation rate. Section 4 uses the Australian industry price data, along with US industry price data used by Ball and Mankiw, to test the implications of the model. It ends with econometric tests of the exogeneity of the key explanatory variable in the industry-price regressions. Section 5 concludes.

Footnote

In the longer-run, the inflation rate is determined by the stance of domestic monetary policy. In the short-run, however, “supply” or relative-price shocks also have a strong influence. [1]