Academic journal article Journal of Money, Credit & Banking

Inflation and Costly Price Adjustment: A Study of Canadian Newspaper Prices

Academic journal article Journal of Money, Credit & Banking

Inflation and Costly Price Adjustment: A Study of Canadian Newspaper Prices

Article excerpt

SINCE KEYNES (1936), a central issue in macroeconomics has been the rigidity of nominal prices. The development of microfoundations of macroeconomics in the last 20 years has, if anything, increased the importance of this issue. In fact, it has become so important that it has led two prominent economists to write "A Sticky Price Manifesto" (Ball and Mankiw 1994). This reminds us of another famous manifesto written by two prominent economists (Marx and Engels 1848). The recent experience of communism has underscored the fact that manifestos rise or fall on the basis of empirical evidence. In this paper we analyse some evidence in favour of sticky prices.

An important basis for sticky prices is the fact that, even under rapid inflation, nominal prices are changed infrequently. One explanation is that nominal price adjustment is costly. This has led to the costly price adjustment approach, started by Barro (1972) and developed by Sheshinski and Weiss (1977, 1983) and others. The costs of changing the nominal price can be divided into three types. The first is the literal or menu cost (printing labels, informing salesmen and customers, etc). The second are the costs of the decision process: collecting information, analysing changes in the frictionless optimal real price and deciding on the new nominal price. Lastly, there are costs resulting from unfavourable reaction of competitors and/or customers to price changes. (1)

The basic microeconomic model (Sheshinski and Weiss 1977) implies that the optimal pricing policy is of the (s, S) type. The firm allows the real price to vary between two price bounds. Whenever inflation erodes the real price to the lower bound, s, the nominal price is then raised so that the new real price is equal to the upper bound, S. Higher inflation implies a higher value of S, a lower value of s and larger price changes; the effect on the frequency of adjustment is ambiguous. (2)

The problem with the literature is that existing empirical studies, while providing ample evidence on the rigidity of individual nominal prices, sometimes reject the basic microeconomic model. In Lach and Tsiddon (1992) and in Kashyap (1995), for some goods, the size of adjustment falls when the inflation rate increases while in Cecchetti (1986) and Dahlby (1992) inflation does not appear to affect the price bounds.

These rejections are, perhaps, not surprising as the assumptions of the basic model are difficult to meet in empirical work. Sheshinski and Weiss (1977) assume that the firm is an unregulated monopoly that produces a single, perishable good, the rate of inflation is constant, the cost of price adjustment is lump-sum (i.e., independent of the size or frequency of price changes) and demand and real costs are constant. Testing requires specialized data (prices of individual goods in individual stores or firms) which are difficult to obtain and so available data violate many, if not most, of these assumptions. Since optimal pricing policy may be quite different in other environments (3) these rejections may not be robust and have been largely ignored.

Further progress of the empirical literature requires, therefore, careful evaluation of the assumptions of the model. The contribution of this paper is twofold. First, our data allow us to distinguish between monopoly and oligopoly firms. We provide the first evidence on price behaviour of unregulated monopolies. (4) The distinction is crucial to the menu cost models; optimal oligopoly pricing with menu costs is a difficult problem and few theoretical results are available. A notable exception is Slade (1999) who analyses an oligopolistic market and finds that strategic consideration exacerbates price rigidity: price changes are larger and more frequent than under monopolistic competition.

Second, we ask how to address the fact that, in actual data, the inflation rate, demand, and real costs all vary over time. We test the model under alternative approaches to the formulation of optimal policy in a nonstationary environment. …

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