Tuesday, June 20, 2006

Question about Sticky Prices

A student emails me a question about price adjustment:

Dear Professor Mankiw:

My name is [name withheld], a student of financial economics. Today I immensely enjoyed your Macroeconomics book (2000) at a library. Your book should be among the best in its category.

I have some comments on "Sticky prices."

Although 39% of firms may change prices once a year, doesn't the economy demonstrate continuous or smooth changes? Don't CPI, PPI, and other indices change every month, every week, and everyday? Today, hundreds of firms would have changed their prices. Tomorrow another hundreds of firms would do so. Each firm changes their prices at different time.

Would you please make a brief response. Thank you very much.

[name withheld]

Your letter raises an important question: how can we go from the firm-level observation that many prices are adjusted only intermittently to the economy-wide issue of adjustment of the price level (as measured by the CPI) to macroeconomic shocks? This question, it turns out, is hard, and there has been a lot of research on it.

One famous paper, by Caplin and Spulber, showed that under some conditions, the overall price level will not be sticky in response to monetary shocks, even though individual prices are sticky. The reason is that those prices that are changed move by a large amount. So when the money supply rises by 1 percent, the overall price level rises by 1 percent immediately, even though many individual prices are stuck at old levels. For example, under the Caplin-Spulber conditions, 90 percent of prices could be sticky, while 10 percent of prices are adjusted upward by 10 percent. The overall price level parallels the money supply without any delay.

The Caplin-Spulber paper was important for illustrating that individual price stickiness need not imply aggregate price stickiness. Yet these results require strong assumptions about the economic environment. A subsequent paper by Caplin and Leahy relaxed the Caplin-Spulber assumptions and reached very different conclusions. And there has been considerable work on the topic since then.

The subsequent literature is too vast to explain in a brief blog entry. I assume you were reading my intermediate macro text. If you want to pursue the subject further, I recommend you continue your studies with the graduate-level textbook Advanced Macroeconomics by David Romer.