DP10138 Menu Costs, Aggregate Fluctuations, and Large Shocks

Author(s): Peter Karadi, Adam Reiff
Publication Date: September 2014
Keyword(s): monetary policy transmission, price change distribution, state-dependent pricing, value-added tax
JEL(s): E31, E52
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10138

How do frictions in price setting influence monetary non-neutrality? We revisit this classic question in a quantitative menu cost model with multi-product firms that face idiosyncratic shocks with unsynchronized stochastic volatility. The model matches the unconditional distribution of price changes and successfully predicts new evidence on pricing responses to large value-added tax shocks. In particular, it captures both the exploding fraction of price changes and the shape of their conditional distribution, outperforming alternative models. The model generates near money neutrality even to small nominal shocks.