Price Setting, Inflation Dynamics, and Monetary Policy

Sammanfattning: This thesis consists of three self-contained essays. Essay 1: Staggered prices are a fundamental building block of New Keynesian DSGE models. In the standard model, prices are uniformly staggered, but recent empirical evidence suggests that deviations from uniform staggering are common. This essay analyzes how synchronization of price changes affects the response to monetary policy shocks. I find that even large deviations from uniform staggering have small effects on the response in output. Aggregate dynamics in a model of uniform staggering may serve well as an approximation to a more complicated model with some degree of synchronization in price setting. Essay 2: The welfare cost of inflation in the canonical New Keynesian DSGE model is due to price dispersion. Calibration of the model to match an empirically plausible markup leads to very elastic demand curves. As a consequence, even a small dispersion of prices leads to large distortions in households' allocation of consumption among different goods and substantial welfare losses. The empirical literature suggest, however, that demand adjusts sluggishly to price changes. In this essay, customer markets are integrated in an otherwise standard New Keynesian model by assuming that individual households can only optimize their consumption of an individual good at irregular intervals. With this specification, the welfare loss due to price dispersion is significantly smaller. Moreover, output gap stabilization should be assigned a much more important role in the conduct of monetary policy than previously found in the literature. Essay 3: A main argument for New Keynesian DSGE models is that they have solid microfoundations, but staggered prices and wages are exogenously imposed. How plausible are sticky prices and wages in these models? We show that, in a standard model, there is implausibly large volatility of production and labor supply on the microeconomic level. Also, rationality is violated as households sometimes end up with negative markups, and substantial "menu costs" are needed in order to rationalize the assumed behavior. We present an alternative model with efficiency wages and customer markets that has similar dynamics at the macro level and more plausible behavior on the micro level. In the alternative model, substantially smaller menu costs are required to support an equilibrium with sticky prices and wages.