Working Paper: NBER ID: w14392
Authors: Patrick J. Kehoe; Virgiliu Midrigan
Abstract: In the data, prices change both temporarily and permanently. Standard Calvo models focus on permanent price changes and take one of two shortcuts when confronted with the data: drop temporary changes from the data or leave them in and treat them as permanent. We provide a menu cost model that includes motives for both types of price changes. Since this model accounts for the main regularities of price changes, its predictions for the real effects of monetary policy shocks are useful benchmarks against which to judge existing shortcuts. We find that neither shortcut comes close to these benchmarks. For monetary policy analysis, researchers should use a menu cost model like ours or at least a third, theory-based shortcut: set the Calvo model's parameters so that it generates the same real effects from monetary shocks as does the benchmark menu cost model. Following either suggestion will improve monetary policy analysis.
Keywords: price changes; monetary policy; menu cost model
JEL Codes: E12; E5; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Calvo model (excluding temporary price changes) (E19) | overestimate real effects of monetary shocks (E49) |
| temporary price changes included in Calvo model (E39) | prices change every 3 weeks (D41) |
| menu cost model (E10) | accurately predicts real effects of monetary shocks (E47) |
| Calvo model parameters adjusted (C51) | prices change on average every 17 weeks (E30) |
| temporary changes out approach (D51) | inflated estimates of monetary effects (E39) |
| temporary changes in approach (B52) | underestimates monetary effects (E40) |