Academic journal article Journal of Money, Credit & Banking

Adapting Prices or Quantities in the Presence of Adjustment Costs?

Academic journal article Journal of Money, Credit & Banking

Adapting Prices or Quantities in the Presence of Adjustment Costs?

Article excerpt

It is often hypothesized that costs of adjusting both price and quantities may have important implications for the macroeconomic adjustment process, not least to nominal shocks. We analyse this in an explicit intertemporal general equilibrium model considering the empirically relevant case of fixed costs of adjusting prices and fixed and variable costs of adjusting quantities. We find that the presence of both price and quantity adjustment costs changes the response to shocks significantly. It is an implication that "small" shocks do not support the "menu-cost case" but rather both fixed prices and quantities (rationing). A numerical analysis based on available evidence on adjustment costs is used to illustrate the likelihood that the various adjustment patterns actually arise.

Keywords: menu-costs, nominal rigidities, price and quantity adjustment.

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THE ROLE TAKEN BY prices and quantities in the macroeconomic adjustment process to various types of shocks is a classical theme with wide policy implications not least for monetary policy. While the understanding of the consequences of failures of prices or wages to adjust is quite good, the more difficult problem of explaining the reasons for these adjustment failures remains. This is potentially very important since this leaves open the question whether, e.g., particular forms of policy interventions would induce price and wage adjustment.

A prominent candidate for explaining failures of prices or wages to adjustment is the presence of adjustment costs. The basic idea underlying models featuring adjustment costs is that adaptation is costly. The earlier decisions can be made, the smaller the costs, while delaying decisions entails additional costs. The costs can be related to both the process of deciding which adjustments should be made, and the magnitude and speed of adjustment. These problems are particularly important in the presence of uncertainty since realization of shocks naturally gives reason for considering adjustments. Adjustments can involve both price and quantity changes, and in the early literature on uncertainty, a distinction was made between different modes of behaviour depending on whether a given variable was flexible or fixed ex-post to realization of shocks; i.e., it was implicitly assumed that the costs of ex-post adjustment are either infinite or zero (see, e.g., Baron, 1971, Leland, 1972, and Andersen, 1994, who provide a survey and further references to this strand of literature).

The "menu-cost" literature made the important point that the intermediate case is both more interesting and empirically relevant and worked out in detail how costs of adjusting prices ex-post to shocks affects whether prices are adjusted and therefore how the adjustment burden to nominal shocks is shared between prices and quantities. The first explicit analysis of price adjustment costs is found in Barro (1972), but the menu-cost literature took off with the contributions by Mankiw (1985) and Rotemberg (1982) (see, e.g., Rotemberg, 1987, and Ball, Mankiw, and Romer, 1988, for introductions and references to the literature on menu costs). Due to its simplicity, it has over recent years gained momentum as an important explanation why nominal prices do not take the full adjustment burden to nominal shocks as predicted by the classical neutrality result. The main insight of these models can also be phrased in the way that small deviations from the optimal price have second-order consequences for profits (Akerlof and Yellen 1985a, 1985b). Hence, even very small costs of changing prices make it optimal to keep nominal prices unchanged to (small) changes in the state of nature. Moreover, in a setting with inefficient low activity due to market power, this may have first-order welfare effects.

The implicit assumption underlying menu-cost models is that it is costless to make ex-post adjustments of quantities. This is in many cases a restrictive assumption since changes in production may require explicit decisions and involve changes in the use of inputs relative to what was initially contracted. …

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