How fast do prices adjust to changes in economic conditions? Answering this is crucial in the assessment of the welfare costs of inflation and the real effects of nominal shocks. The literature provides apparently conflicting answers to this question: whereas aggregate price indices were found to be very persistent, more recent work starting with Bils & Klenow (2004) has shown that individual prices adjust frequently.
Boivin, Giannoni and Mihov (2009) show that this puzzle can be resolved by distinguishing between the response of individual prices to macroeconomic shocks common to every sector or product, and their response to microeconomic shocks specific to a sector or product. They find that sectoral prices adjust sluggishly to the former but rapidly to the latter. This result has in turn spurred a debate on what theoretical model of price-setting could rationalize such different response of individual prices to different types of shocks.
In this paper, we emphasize the distinction between global shocks common to every location worldwide, and local shocks specific to a location. We find that, for both macro and micro shocks alike, global components are associated with a much slower speed of price adjustment than local ones. Furthermore, we find that the difference in the speed of price adjustment in response to local macro versus local micro shocks is smaller than the difference in the speed of price adjustment in response to global versus local shocks of any type. Moreover, global micro shocks are associated with a slower speed of price adjustment than local macro shocks.
These findings imply that considering only a single type of micro or macro shock as in previous work hides important heterogeneity in their effects that could lead to misleading inferences about the relative persistence of local macro shocks (typically monetary ones) in micro prices. Finally, we find that more volatility in local conditions is associated with slower price adjustment in response to global shocks, with this local-global link more than twice as large as the one between volatility in micro conditions and price adjustment in response to macro shocks. Overall, our results suggest that the global-local distinction is a much more striking one and no less important in assessing models of price setting, than the macro-micro split considered in previous work.
