Sticky Prices and Monetary Policy Shocks *

Article excerpt

A large literature in macroeconomics holds that, because of sticky prices, changes in monetary policy temporarily affect the real quantifies of goods and services produced. The magnitude and persistence of the effects should vary across goods in relation to their extent of price stickiness. We test this hypothesis using evidence on the importance of price rigidities across categories of consumption in the United States.

We find that they do not. The short-run responses of relative prices are opposite the predicted responses. Furthermore, the monetary policy shocks show persistent effects on both relative prices and relative quantities, not the transitory effects predicted. Our findings are inconsistent with the joint hypothesis that the sticky-price model well depicts the actual economy and that commonly used monetary policy shocks represent truly exogenous shifts.

According to unpublished data on individual consumer prices collected by the Bureau of Labor Statistics (BLS) of the U.S. Department of Labor, the frequency of price changes varies dramatically across goods. Prices of newspapers, men's haircuts, and taxi fares change less than once every two years on average. At the other extreme, prices of gasoline, tomatoes, and airfares change more than once a month on average. We exploit this diversity. We classify goods by how frequently they display monthly price changes in the BLS microeconomic data. We then ask, If an expansionary monetary policy change occurs, do goods with flexible prices respond differently than goods with prices that rarely change? For example, when the Federal Reserve cuts interest rates unexpectedly, do flexible-price goods such as gasoline increase in price and fall in real quantity consumed compared to sticky-price goods such as film processing?

Stickiness of Consumer Prices

To construct the consumer price index (CPI), the BLS collects retail prices on more than 80,000 items a month. It collects prices on everything from broccoli to brain surgery. Bils and Klenow (2002) analyze some of the BLS data in detail, presenting evidence on 350 categories of goods and services. They find that differences in price flexibility are large and persistent across categories.

The accompanying table summarizes the evidence for broad categories of consumption over 1995-97. The first row shows that the median duration of prices across the 350 categories is 4.3 months. The next two rows show median durations separately for goods (about 30 percent of consumption) and services (about 41 percent of consumption). Prices are more flexible for goods (duration 3.2 months) than for services (7.8 months).

The next seven rows in the table show durations for the seven CPI major groups. At the flexible end are transportation prices (for example, new cars, airfares), with a median duration just under two months. At the sticky extreme are prices for medical care (drugs, physicians' services) and entertainment (admissions, newspapers, magazines, books), with median times between price changes of about 15 months and 10 months, respectively.

In the final two rows in the table, we distinguish between raw goods and processed goods and services. By raw goods we mean those with little value added beyond a primary input, for instance, gasoline or fresh fruits and vegetables. (1) As expected, raw goods display more price flexibility (median duration 1.6 months) than do processed goods and services (5.7 months).

A Sticky-Price Model

As described above, we wish to examine whether popular measures of monetary policy shocks have differential effects across types of consumption with varying underlying price flexibility. Here we use a simple general equilibrium model to illustrate how responses should vary with price stickiness. We build closely on the work of Charm, Kehoe, and McGrattan (2000). They model monopolistically competitive firms with staggered price-setting of a fixed duration. …