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New Keynesian Macroeconomics
Chapter 2: Stylized Microeconomic Facts of the Price Setting Mechanism
Prof. Dr. Kai Carstensen
ifo Institute for Economic Research and LMU Munich
Prof. Dr. Kai Carstensen (LMU Munich)
New Keynesian Macroeconomics, Ch. 2
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Evidence based on micro price data
Peter J. Klenow and Benjamin A. Malin (2010) Microeconomic
Evidence on Price-Setting, NBER Working Paper No. 15826.
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Evidence based on micro price data
Data sources
In the last years, large datasets containing detailed quantitative price data underlying CPI or PPI
calculations became available.
Include a large number of monthly price quotes for individual products over several years.
Broadly representative of national consumer expenditures.
Moreover, scanner datasets provide an interesting data source to study price stickiness.
Coverage of a narrower set of goods
However, they provide deeper information (i.e. more items per outlet, information on quantities sold)
and are available at higher frequencies (usually weekly)
Recently, attempts have been made to collect price information from retailers’ websites: “Billion Prices
Project”. Advantages: daily frequency, large set of countries, detailed item-specific information.
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Evidence based on micro price data
Frequency of price changes
Fact 1: Prices change at least once a year.
In the U.S., consumer prices change about every 4 months, while producer prices change every 6-8
months. Prices are somewhat stickier in the Euro area (around once a year).
Difficult to match this microdata fact with aggregate outcomes: VAR studies find that monetary shocks
have long-lasting real effects.
Hence, nominal stickiness seems insufficient to explain sluggish price adjustment observed in aggregate
data. It is thus usually combined with a “contract multiplier” (Taylor, 1980).
Examples: real rigidities such as strategic complementarities or countercyclical markups, sticky plans and
sticky information.
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Evidence based on micro price data
Frequency of price changes
Fact 2: Sales and product turnover are often important for micro flexibility.
Different types of price changes may lead to diverging implications for macro models!
In the U.S.: large price discounts and product turnover make up for about one-third of consumer price
changes. Sales are however less important in the Euro area.
Sale-related price changes are of a temporary nature and thus partially “cancel out” in the aggregate.
However, in the U.S., sale-related price changes still lead to increased “macro-flexibility” and thus a
reduced overall degree of nominal stickiness.
Prof. Dr. Kai Carstensen (LMU Munich)
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Evidence based on micro price data
Frequency of price changes
Fact 3: Reference prices are stickier and more persistent than regular prices.
Reference price: most often quoted price within a given time period. Thus, Reference price changes are
yet another form of price changes next to regular and sale-related price changes.
In U.S. CPI: Many temporary regular price changes but sticky reference prices. On average, reference
prices change every 10-11 months.
Deviations from reference prices do not “cancel out” across items and thus affect aggregate inflation.
Reference price inflation is more persistent than regular price inflation.
Thus, reference price changes lead to a more persistent effect of monetary policy, which can be explained
by sticky plan type pricing mechanisms applying for this type of price changes.
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Figure: Posted vs. Reference Price Inflation, U.S. CPI
Source: Klenow and Malin, 2010.
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Evidence based on micro price data
Frequency of price changes
Fact 4: There is substantial heterogeneity in the frequency of price changes across goods.
Considerable cross-category heterogeneity: frequency of monthly price change reaches from 2.7%
(intracity mass transit) to 91% (regular unleaded gasoline).
Across countries, service prices are stickier than goods prices. Among goods, “raw” goods such as
energy and fresh food are more flexible than processed goods.
In macro models, heterogeneity across goods can be combined with strategic complementarities to
increase the degree of price stickiness and thus generate stronger real effects of monetary policy
Example: firms at different production stages show different degree of price flexibility - price stickiness
accumulates through production chain.
Prof. Dr. Kai Carstensen (LMU Munich)
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Price Change Frequency Figure: Price Change Frequency by Product Category
Entry Level Items
Source: Klenow and Malin, 2010.
Data are for the top three cities (New York, Los Angeles, and Chicago) January 1988 through October 2009. Each bar corresponds to an ELI product
category (weighted by expenditure), and price change frequency is calculated as the weighted average across quotes within the ELI. Prices include sales
and regular prices.
Prof. Dr. Kai Carstensen (LMU Munich)
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Evidence based on micro price data
Frequency of price changes
Fact 5: More cyclical goods change prices more frequently.
One specific form of cross-product heterogeneity: in the U.S. CPI, more frequent price changes are
observed for products with more procyclical real consumption growth.
Examples: transportation (cars, airfares) and apparel.
This relationship may appear because cyclical shocks imply a larger degree of macro price flexibility.
Thus, models that take into account this relationship would predict effects of monetary policy that are less
pronounced relative to models that assume exogenous frequency of price changes.
This is in contrast to the effect of firm-specific sources of heterogeneity (e.g. firm-specific menu cost)
which tend to amplify nominal stickiness.
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Price Change Frequency Figure: Frequency vs. Cyclicality in the U.S. CPI
Cyclicality
Source: Klenow and Malin, 2010.
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Evidence based on micro price data
Size of price changes
Fact 6: Price changes are big on average, but many small changes occur.
Both in the U.S. and in the Euro area, micro price changes are an order of magnitude larger than
necessary to be in line with aggregate inflation. Thus, firm-specific factors are important for price setting
relative to macro shocks.
At the same time, many price changes are small.
Implications for macro models:
Not in line with state-dependent models with a single, large menu cost: “missing middle” in the distribution
of price changes in these models.
Time-dependent models à la Taylor or Calvo can match this fact.
However, more complicated menu cost models are also able to reflect this observation (e.g. variable menu
costs).
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Figure: Distribution of Price Changes
Source: Klenow and Kryvtsov, 2008.
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Evidence based on micro price data
Dynamic features of price changes
Fact 7: Relative price changes are transitory.
A consequence of large idiosyncratic price changes is that also relative price changes are big. However,
these relative price movements are temporary.
This implies that for two goods there is generally a persistent underlying relative price but there might be
large temporary deviations.
Implications for macro models:
Big relative price changes imply: either strategic complementarities are weak or idiosyncratic shocks are
large. In the former case, the contract multiplier and thus the real effects of monetary policy are small.
Temporary relative price changes may also reflect micro flexibility in a world of macro stickiness. For
example, if macro shocks are relatively unimportant compared to firm-specific shocks, firms update their
macro information/macro plan seldom while they often react to the large firm-specific shocks.
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Evidence based on micro price data
Dynamic features of price changes
Fact 8: Price changes are typically not synchronized over the business cycle.
Example for synchronization: sellers accelerate price increases in response to positive monetary shocks
and postpone them following negative monetary shocks. This may lead to reduced real effects of
monetary policy.
In the U.S. for moderate inflation periods, firms do typically not synchronize price setting. In Germany, the
frequency of price changes seems to react to swings in inflation. In countries with strong changes in
inflation levels like Mexico, there is even more synchronization.
Lack of synchronization has implications for macro models:
Consistent with time-dependent models and state-dependent models with large firm-specific shocks.
Evidence in favor of staggered nominal price adjustment. Combination of staggered price adjustment and
strategic complementarities raises the degree of nominal stickiness.
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Figure: Retail Price Inflation and Fraction of Price Changing Firms
Source: Carstensen and Schenkelberg, 2011.
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Evidence based on micro price data
Dynamic features of price changes
Fact 9: Neither frequency nor size is increasing in the age of a price.
In both the U.S. and the Euro area, the hazard rate of price changes is decreasing over the first months
and is flat afterwards. If sale-related price changes are excluded, the downward slope is reduced.
Relation to theoretical macro literature:
Not in line with intuition of standard state-dependent models: here, the probability of a price change
increases in time as the distance between actual and optimal price rises.
More complicated menu cost models better able to reflect this fact.
Flat hazard rate accords with predictions of standard time-dependent models (Calvo model).
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Figure: Weighted Hazard Rates for Regular Prices, U.S. CPI
Source: Klenow and Kryvtsov, 2008
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Evidence based on micro price data
Dynamic features of price changes
Fact 10: Price changes are linked to wage changes.
Firms with a relatively high share of labor costs in total costs adjust their prices less frequently.
Possible reason: wages typically adjust less frequently than other input prices due to wage contracts that
are fixed over a certain time period.
Thus, sluggish wage adjustment can contribute to an increased overall degree of nominal stickiness in
several ways:
Directly, because wages are stickier than prices.
Indirectly by lowering the frequency of price adjustment.
Wage adjustment is largely time-dependent; this pattern could feed through to price adjustment.
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Evidence based on firm surveys
S. Fabiani, M. Druant, I. Hernando, C. Kwapil, B. Landau, C. Loupias,
F. Martins, T. Mathä, R. Sabbatini, H. Stahl, and A. Stokman (2006)
What Firms’ Surveys Tell Us about Price-Setting Behaviour in the Euro Area,
International Journal of Central Banking, September 2006.
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Evidence based on firm surveys
Data sources
Analyzing quantitative price data may not be sufficient to understand determinants of firms’ price setting
mechanism. Conducting surveys allows to ask firms directly for their price setting strategies.
Survey data: summary of evidence from surveys conducted in nine Euro area countries in 2003 and 2004.
11 stylized facts emerge from common evidence of these countries.
Advantages of this kind of data source:
Separate assessment of two stages of price setting: price review stage and implementation stage.
Insights concerning information set used in the review of prices.
Possibility to cross-check evidence from quantitative price data.
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Evidence based on firm surveys
Price reviews
Fact 1: Both time- and state-dependent pricing strategies are used by Euro area firms.
Around one-third of the companies report that they follow mainly time-dependent rules.
The remaining two-thirds state that they adopt pricing rules with some elements of state-dependence.
These firms mainly use a mixed strategy.
This implies that the overall degree of price stickiness in the Euro area is somewhat less pronounced
compared to predictions of purely time-dependent models.
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Evidence based on firm surveys
Price reviews - information set
Fact 2: Around half of the firms review their prices taking into account a wide range of information.
These firms include both past and expected economic developments in their information set; one-third of
them show a backward-looking behavior.
Important macro implications of the information set used by firms:
The observed pattern accords with recent attempts to estimate hybrid versions of the New Keynesian
Phillips curve, which deviate from fully optimizing behavior.
Elements of backward-looking behavior may provide an additional source of stickiness.
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Evidence based on firm surveys
Frequency of price reviews
Fact 3: In most countries the modal number of price reviews lies in the range of one to three times a
year.
Heterogeneity across sectors: firms in the services sector review prices less frequently than firms in other
sectors.
Moreover, in most countries, firms facing high competitive pressure carry out price reviews more
frequently.
Potential reasons for infrequent price reviews:
Possibly sporadic arrival of new information (sticky information).
Costs of price reviews: it may be optimal for firms not to obtain costly information in certain periods
(rational inattention).
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Evidence based on firm surveys
Price changes
Fact 4: Markup (constant or variable) pricing is the dominant price-setting practice adopted by firms in
the Euro area.
This accords with standard result in models of imperfect competition:
Firms set a price that constitutes a markup over marginal costs. Thus, price rigidities occur because firms
may choose not to adjust following a cost shock.
However, markup pricing depends on the degree of competition faced by the firms; the prices of around
30 percent of firms are shaped by competitors’ prices.
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Figure: Markup and Perceived Competition (Percentages)
low competition
high competition
Source: Fabiani et al., 2006
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Evidence based on firm surveys
Price changes
Fact 5: Price discrimination is common practice for Euro area firms.
Differences across sectors: uniform pricing more common in trade sector, while the degree of price
discrimination is high in manufacturing.
Fact 6: Competitors’ prices on the foreign market and transportation costs are the most relevant factors
for pricing-to-market behavior.
Thus, in some countries there are departures from the law of one price.
Even for firms operating outside the Euro area, exchange rate movements are not as important as
transportation costs, the price of competitors or cyclical demand fluctuations.
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Evidence based on firm surveys
Frequency of price changes
Fact 7: The median firm changes its price once a year.
Differences across sectors: nominal stickiness larger in the services sector and less pronounced in the
trade sector.
As in the case of price reviews, degree of competition is an important determinant of frequency of price
adjustment:
In most countries, firms facing strong competitive pressures adjust their prices more frequently.
Remember: average duration of price spells is an important parameter in the calibration of DSGE models
used for monetary analysis.
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Evidence based on firm surveys
The relationship between price reviews and price changes
Fact 8: Price changes are less frequent than price reviews.
Consistent with the idea that price setting takes place in two stages:
Some degree of stickiness already at the first stage of the process when appropriateness of prices
is reviewed.
Once price review has taken place, not always a price change actually occurs.
Implications for macro models:
This fact contrasts implications of sticky information models, where prices change constantly but price
reviews are less frequent.
Moreover, not in line with models assuming lagged inflation indexation, which is another form of
reoptimization constraints faced by firms in any given period.
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Evidence based on firm surveys
Reasons for price stickiness
Fact 9: Implicit and explicit contracts are the most relevant explanations for sticky prices.
This suggests that price rigidities are associated with customers’ preferences for stable nominal prices.
Other relevant factors are related to cost-based pricing and coordination failure. Menu costs do not
appear to be very important.
Overall, these results indicate that the main impediments to more-frequent price adjustment are
associated with the price-change stage rather than with the price review stage of the price setting process.
Prof. Dr. Kai Carstensen (LMU Munich)
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Figure: The Importance of Theories Explaining Price Stickiness
Countries' scores (unweighted average)
1.2
1.4
1.6
1.8
2.0
2.2
2.4
2.6
2.8
Implicit contracts
Explicit contracts
Cost-based pricing
coordination failure
Judging quality by price
Temporary shocks
Nonprice factors
Menu costs
Costly information
Pricing thresholds
Source: based on Fabiani et al., 2006
Prof. Dr. Kai Carstensen (LMU Munich)
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Evidence based on firm surveys
Factors driving price changes
Fact 10: Cost shocks are more relevant in driving prices upward than downward, while shocks to market
conditions matter more for price decreases than increases.
Asymmetric effects of drivers of price changes:
Price increases more often caused by rising input and labor prices as well as financial costs.
Price decreases often due to changes in demand and competitors’ prices.
Fact 11: Firms in highly competitive markets are more likely to respond to changes in underlying
factors, especially in the case of demand shocks.
Thus, the degree of competition determines the price setting process also with respect to the driving
forces underlying price adjustment.
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