Fernando Alvarez Francesco Lippi

University of Chicago and EIEF

Abstract

We give an analytical characterization of a menu cost model in the spirit of Eichen- baum, Jaimovich, and Rebelo(2011) and Kehoe and Midrigan (2015). In this model firms can change nominal prices freely within a set of two values, which we refer to as a “price plan”. While changes within a plan are free, the plans can be changed only subject to a fixed menu cost. The model generates a persistent “reference” price level and short lived deviations from it, as seen in many datasets.

We analytically solve for the optimal policy of a firm, and for the cumulative impulse response function of output to a once and for all monetary shock. We compare the economy with the 2-price plan with an equivalent menu-cost economy featuring the same number of regular price changes. We show that, for a small monetary shock, the equivalent menu cost economy has an cumulative output IRF three times larger. The smaller effect of the monetary shock is due to the extra flexibility afforded by the price plans to react to the monetary shock. Moreover we show that the introduction of price plans may generate a hump-shaped impulse responses for output as well as a decreasing hazard function for price changes.