The New Keynesian DSGE model has become the workhorse model for monetary policy analysis. Derived from microfoundations, the framework is not only suitable for studying how the economy responds to shocks, and the role of various frictions, but it also provides a welfare criterion for evaluating alternative policies. Remarkably, the central banks loss function emerging from this class of models takes the same form as previously assumed in the literature, penalizing variations in the output gap and inflation. A fundamental difference, however, is that while the literature has traditionally assigned about equal weight to inflation and output gap stabilization, the welfare criterion derived from microfoundations gives a much higher weight to inflation stabilization.
While households prefer a balanced consumption basket, inflation causes relative price dispersion between firms, which affects the allocation of consumption among different goods. Calibration of the model to match an empirically plausible markup, implies very elastic demand curves. As a consequence, even a small degree of price dispersion is very costly in welfare terms, as it implies large distortions in households allocation of consumption among different goods. This is not consistent with the sluggish behavior of market shares estimated in the customer market literature. Gottfries (2002) and Lundin et al. (2009), for instance, find short run price elasticities which are smaller than unity.
In this paper I seek to answer the question how the existence of customer markets affects the welfare cost of inflation and optimal monetary policy. The model I have in mind is one where there are costs associated with the acquisition and processing of information about prices, so that households only occasionally reoptimize their allocation of consumption among different goods. For instance, if different goods are sold at different physical locations, households may chose to only compare price quotes across stores infrequently. This means that information about better shopping opportunities diffuses slowly through the economy. This interpretation is the spirit of the original customer market model proposed by Phelps and Winter (1970). But even if households are fully informed about prices, there may be costs associated with the time and cognitive effort required to optimally allocate consumption between goods. Such frictions, as well as uncertainty about other product attributes, are factors known to give rise to repeat purchase behavior; see Solomon et al. (2006) ch. 8 and references therein. Explicit modelling of information frictions is technically complicated and I therefore resort to a variant of the signaling mechanism proposed in Calvo (1983). I assume that a household allocates consumption among different goods by choosing the relative consumption of each good, i.e., the quantity consumed of the good relative to the total basket consumed. In each period, the household is only allowed to reoptimize for a random fraction of all goods.
The result is a model where a firms market share depends on its lagged market share as well as on current and expected future prices. Ravn et al. (2006) and Nakamura and Steinsson (2009) obtain a similar demand formulation by assuming internal deep habits, i.e., that households form habits in the consumption of individual goods. In contrast to those papers, customer markets in this paper are due to frictions that do not affect households preferences for different goods. Also, because the sluggishness of demand for individual goods pertains to the infrequent reoptimization of households relative consumption, as opposed to the formation of habits in the consumption level, the aggregate demand relation is not affected by the introduction of customer markets. This facilitates the welfare evaluation, as the introduction of customer markets does not change households welfare function, when written in terms of variations of the output gap and the dispersion in consumption across different goods.
Because demand is a function of expected future prices, there is a problem of time inconsistency in price setting. Firms would like to promise low future prices, but renege on these promises when the future arrives. I resolve this problem by assuming that firms commit to state contingent price plans. This assumption is unrealistic if taken literately, but it captures the idea that firms can, to a considerable extent, make promises to their customers. Surveys consistently rank implicit contracts as the most important factor for firms when setting prices. See, e.g., Apel et al. (2001), who report evidence from a survey of Swedish firms, and Fabiani et al. (2007), who review the literature for the Euro area. There is also some narrative evidence available that documents the importance of implicit contracts. Young and Levy (2006) provide evidence for implicit contracts in the marketing of Coca Cola, while Nakamura and Steinsson (2009) survey the media and find numerous examples of firms communicating their intentions not to raise their prices. The ability of firms to commit should be interpreted as a stylized way of modelling ongoing relationships between customers and firms.
Download
Customer markets and the welfare effects of monetary policy
