Mankiw - Sticky Information Versus Sticky Prices

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    STICKY INFORMATION VERSUS STICKY PRICES:A PROPOSAL TO REPLACE THE NEW

    KEYNESIAN PHILLIPS CURVE*

    N. GREGORY MANKIW AND RICARDO REISThis paper examines a model of dynamic price adjustment based on the

    assumption that information disseminates slowly throughout the population.Compared with the commonly used sticky-price model, this sticky-informationmodel displays three related properties that are more consistent with acceptedviews about the effects of monetary policy. First, disinflations are always contrac-tionary (although announced disinflations are less contractionary than surpriseones). Second, monetary policy shocks have their maximum impact on inflationwith a substantial delay. Third, the change in inflation is positively correlatedwith the level of economic activity.

    The dynamic effects of aggregate demand on output andinflation remain a theoretical puzzle for macroeconomists. Inrecent years, much of the literature on this topic has used a modelof time-contingent price adjustment. This model, often called "thenew Keynesian Phillips curve," builds on the work of Taylor[1980], Rotemberg [1982], and Calvo [1983]. As the recent surveyby Clarida, Gali, and Gertler [1999] illustrates, this model iswidely used in theoretical analysis of monetary policy. McCallum[1997] has called it "the closest thing there is to a standardspecification."Yet there is growing awareness that this model is hard tosquare with the facts. Ball [1994a] shows that the model yieldsthe surprising result that announced, credible disinflations causebooms rather than recessions. Fuhrer and Moore [1995] arguethat it cannot explain why inflation is so persistent. Mankiw[2001] notes that it has trouble explaining why shocks to mone-tary policy have a delayed and gradual effect on inflation. Theseproblems appear to arise from the same source: although theprice level is sticky in this model, the inflation rate can changequickly. By contrast, empirical analyses of the inflation process(e.g., Gordon [1997]) typically give a large role to "inflationinertia."

    * We are grateful to Alberto Alesina, Marios Angeletos, Laurence Ball, Wil-liam Dupor, Martin Eichenbaum, Christopher Foote, Xavier Gabaix, MarkGertler, Bennett McCallum, Kenneth Rogoff, Julio Rotemberg, Michael Woodford,and anonymous referees for comments on an earlier draft. Reis is grateful to theFundacao Ciencia e Tecnologia, Praxis XXI, for financial support.co 2002 by the President and Fellows of Harvard College and the Massachusetts Institute ofTechnology.The Quarterly Journal of Economics, November 2002

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    1296UA RT ERL Y JOURN A L OF EC ON OM IC SThis paper proposes a new model to explain the dynamic

    effects of aggregate demand on output and the price level. Theessence of the model is that information about macroeconomicconditions diffuses slowly through the population. This slow dif-fusion could arise because of either costs of acquiring informationor costs of reoptimization. In either case, although prices arealways changing, pricing decisions are not always based on cur-rent information. We call this a sticky -information model to con-trast it to the standard sticky-price model on which the newKeynesian Phillips curve is based.To formalize these ideas, we assume that each period afraction of the population updates itself on the current state of theeconomy and computes optimal prices based on that information.The rest of the population continues to set prices based on oldplans and outdated information. Thus, this model combines ele-ments of Calvo's [1983] model of random adjustment with ele-ments of Lucas' [1973] model of imperfect information.

    The implications of our sticky-information model, however,are closer to those of Fischer's [1977] contracting model. As in theFischer model, the current price level depends on expectations ofthe current price level formed far in the past. In the Fischermodel, those expectations matter because they are built intocontracts. In our model, they matter because some pricesetters are still setting prices based on old decisions and oldinformation.'After introducing the sticky-information model in Section I,we examine the dynamic response to monetary policy in SectionII. In contrast to the standard sticky-price model, which allowsfor the possibility of disinflationary booms, the sticky-informationmodel predicts that disinflations always cause recessions. Insome ways, the dynamic response in the sticky-information modelresembles Phillips curves with backward-looking expectations.

    1. We should also note several other intellectual antecedents. Gabaix andLaibson [2001] suggest that consumption behavior is better understood with theassumption that households update their optimal consumption only sporadically;it was in fact a presentation of the Gabaix-Laibson paper that started us workingon this project. Another related paper is Ball [2000], who tries to explain pricedynamics with the assumption that price setters use optimal univariate forecastsbut ignore other potentially relevant information. In addition, Rotemberg andWoodford [1997] assume a one-period decision lag for some price setters Finally,after developing our model, we became aware of Koenig [1997]; Koenig's model ofaggregate price dynamics is motivated very differently from ours and is applied toa different range of questions, but it has a formal structure that is similar to themodel explored here.

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    1298UA RT ERL Y JOURN A L OF EC ON OM IC Sever, but arrives randomly. Every period, a fraction X of firmsadjust prices. Each firm has the same probability of being one ofthe adjusting firms, regardless of how long it has been since itslast price adjustment.

    We start with three basic relationships. The first concernsthe firm's desired price, which is the price that would maximizeprofit at that moment in time. With all variables expressed inlogs, the desired price is

    *_Pt-ah.This equation says that a firm's desired price p* depends on theoverall price level p and output y. (Potential output is normalizedto zero here, so y should be interpreted as the output gap.) Afirm's desired relative price, p* p, rises in booms and falls inrecessions.

    Although we will not derive this equation from a firm's profitmaximization problem, one could easily do so, following Blan-chard and Kiyotaki [19871. Imagine a world populated by identi-cal monopolistically competitive firms. When the economy goesinto a boom, each firm experiences increased demand for itsproduct. Because marginal cost rises with higher levels of output,greater demand means that each firm would like to raise itsrelative price.

    In this model, however, firms rarely charge their desiredprices, because price adjustment is infrequent. When a firm hasthe opportunity to change its price, it sets its price equal to theaverage desired price until the next price adjustment. The ad-justment price x is determined by the second equation:

    x,=E1 -. J = 0

    According to this equation, the adjustment price equals aweighted average of the current and all future desired prices.Desired prices farther in the future are given less weight becausethe firm may experience another price adjustment between nowand that future date. This possibility makes that future desiredprice less relevant for the current pricing decision. The rate ofarrival for price adjustments, X, determines how fast the weightsdecline.

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