Ebook On the Importance of Sectoral Shocks for Price-setting
A central element of a majority of contemporary macroeconomic models is the assumption of nominal rigidities in goods markets. The rationale for incorporating price stickiness into these models is provided by the fact that there exists strong empirical evidence in favor of stickiness in prices at an aggregate level. Moreover, the empirical fit of models usually improves considerably when nominal rigidities are allowed for. A standard assumption in DSGE models is Calvo pricing, where firms adjust prices according to staggered contracts (time-dependent pricing). Alternative assumptions include state dependent pricing, information frictions or rational inattention.
The relatively broad consensus about the importance of stickiness in nominal goods prices that emerged, has been challenged in recent years, however. Newer studies that analyze the behavior of micro price data have come to somewhat puzzling results: They find that these prices are not only very volatile, but also exhibit low persistence, in stark contrast to the findings concerning the behavior of aggregate data.
To reconcile the evidence on disaggregate and aggregate prices, several explanations have been put forward. One strand of the literature argues that the apparent persistence of aggregate inflation may be the result of an aggregation bias which arises as the consequence of aggregating heterogeneous sectoral price series. Other authors such as Cogley and Sargent (2005) or Clark (2006) argue that the observed aggregate persistence of prices may reflect a structural break in the mean inflation during the sample. A third explanation presented in Boivin et al. (2008) states that the differences in inflation persistence at the aggregate and disaggregate level may be due to different responses of aggregate and sectoral prices to macroeconomic and sector-specific shocks.
Decomposing a broad set of disaggregate sectoral price data into an aggregate and an idiosyncratic or sectoral component these authors find that the aggregate component exhibits considerable persistence but contributes only little to changes in sectoral prices. The sectoral component on the other hand shows no persistence but is very volatile and explains most of the movements in sectoral prices. Thus, the puzzling evidence on the different behavior of disaggregate and aggregate prices can be attributed to the fact that the former are mostly determined by very volatile sectoral shocks with low persistence whereas the latter are pre-dominantly influenced by highly persistent aggregate shocks with low volatility.
The results by Boivin et al. (2008) are confirmed in a recent study by Mackowiak et al. (2009). Similar to Boivin et al. (2008) these authors decompose a large set of disaggregate monthly U.S. sectoral consumer price data into an aggregate and a sectoral component. They find that the sectoral component not only explains the bulk of variations in sectoral prices but that this component also shows no sign of persistence. In a second step, these authors relate their findings to three different models of price-setting and ask whether any of these models is capable to explain the observed patterns of sectoral price changes.
The three models that the authors consider are multi sector versions of the Calvo (1983) model, the sticky-information model a la Mankiw and Reis (2002) and the rational-inattention model by Mackowiak and Wiederholt (2009). They show that both the Calvo and the sticky-information model are compatible with the observed pattern of sectoral price dynamics only for extreme parameter values and conclude that the rational inattention model fits the observed behavior of sectoral prices best since it postulates that firms react more to sector-specific shocks than to aggregate macroeconomic shocks.
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