Academic journal article Economic Inquiry

Inflation and Asymmetric Output Adjustments by Firms

Academic journal article Economic Inquiry

Inflation and Asymmetric Output Adjustments by Firms

Article excerpt


Recent empirical research has rejuvenated interest in the idea that output responds asymmetrically to monetary shocks. Cover [1988] found that in the USA during the post-WWII period positive shocks to the money supply had no effect on output, whereas negative shocks reduced output. His results have been corroborated by De Long and Summers [1988] and Morgan [1993] using different time periods and measures of monetary shocks. Results from Karras [1996a,b] suggest output asymmetry may be an international phenomenon.

The reasons for output asymmetry remain unclear. They may be due to asymmetries anywhere in the transmission of monetary shocks to output. Asymmetric price adjustment by firms is one possible explanation, but to date the evidence concerning price asymmetry has been mixed. Using data from 38 countries, Karras [1996b] finds no evidence of price asymmetry in response to money supply shocks, whereas studies of the effect on inflation of aggregate output gaps by Laxton, Meredith and Rose [1995] and Turner [1995] imply that money supply shocks are more inflationary as an economy approaches full capacity and less inflationary when an economy approaches low capacity.

The aim of this paper is to test whether output responds asymmetrically to shocks and to evaluate the role of firm pricing behavior. Our approach is different from previous studies in several respects. We use micro-level firm data, we evaluate both output and price asymmetry for a common sample of firms, and we evaluate the influence of inflation. The only previous empirical work examining the influence of inflation on output asymmetry is Rhee and Rich [1995] who find that the asymmetric relationship between monetary shocks and aggregate output revealed by Cover is influenced by inflation.

We use individual firm data, obtained by a survey of New Zealand manufacturing firms, to estimate a model of output and price change based on a theoretical model of price and output asymmetry developed by Ball and Mankiw [1994]. They consider a situation in which firms make regularly scheduled price changes and, by paying a menu cost, can also make special adjustments in response to shocks to desired price. The presence of menu costs of price adjustment implies a zone of no-price-change over which shocks to desired price will not result in a change in actual price. Inflation affects the opportunity cost of not changing price and therefore the position of this zone of no-price-change. Asymmetries in the response of prices to shocks therefore arise naturally when there is positive trend inflation and are predicted to be more pronounced at higher rates of inflation.

Ball and Mankiw suggest that a corollary of price asymmetry is output asymmetry. At high inflation prices are predicted to be more responsive to positive shocks than to negative shocks and output more responsive to negative shocks than to positive shocks. As inflation falls these asymmetries are predicted to become less pronounced.

We evaluate output and price asymmetry and the influence of inflation in two ways. First, we estimate the zone of no-price-change and the zone of no-output-change and evaluate how inflation affects the position of these zones. Second, we evaluate how the response of prices and output to positive and to negative cost and demand shocks vary with inflation.

Using ordered-probit analysis, we find evidence of output asymmetry and price asymmetry which are systematically related to inflation. Furthermore, the relative behavior of output and prices is consistent with price asymmetry being an explanation for output asymmetry.

The remainder of the paper is structured as follows. The second section explains why firm prices and output may respond asymmetrically to shocks and the potential role of inflation in this process. The third section explains the survey data used to test for asymmetry at different rates of inflation. …

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