The nature of price-setting decisions by firms has long played a pivotal role underlying controversies in macroeconomics. Whereas real business cycle (RBC) models assume that firms with full information are free to set prices optimally at all times, New Keynesian models are typically defined by departures from the assumption of flexible prices. Recent work has also emphasized the implications of deviating from the assumption of full-information in price setting. This paper is motivated by the idea that a single assumption about the price-setting decision process by firms may be insufficient to adequately capture macroeconomic dynamics by missing potentially important interactions among heterogeneous firms.
Indeed, firm-level evidence indicates striking heterogeneity in price setting as well as significant information costs. We develop and estimate a dynamic stochastic general equilibrium model that allows for four commonly assumed price-setting sectors to coexist and interact via their price-setting decisions. Our results indicate heterogeneity in price-setting behavior cannot be rejected. Importantly, strategic interaction across sectors changes the qualitative behavior of the inflation dynamics within each sector. Thus, the hybrid model behaves differently than the sum of its parts.
To assess the importance of heterogeneity in the price-setting behavior of firms, we consider a continuum of monopolistic producers of intermediate goods, divided into four segments, each of which uses a different price setting approach. These include sticky-prices, sticky-information, rule-of-thumb, and full-information flexible-price firms. This setup is nested in an otherwise standard New Keynesian model with a representative consumer and a central bank. The model also allows for a stochastic trend in technology and non-zero trend inflation. The parameters of the model, including the share of each type of firm, are estimated jointly using a method of moments approach. This delivers a set of predicted moments for the observable variables that can be directly compared to those of the data.
Our main finding is that no single assumption about the price-setting behavior of firms is sufficient to adequately reproduce the moments of the data. However, while heterogeneity in price-setting behavior across firms cannot be rejected, we find that sticky-price firms play a predominant role in driving macroeconomic dynamics. In the estimates of the nested model, sticky-price firms account for more than fifty percent of firms, with the remaining balance divided almost equally between flexible (17%), rule-of-thumb (16%), and sticky information (13%) firms. Overall, the model is able to match the qualitative features of the data, such as the high persistence of inflation and interest rates as well as the fact that inflation leads interest rates and output growth, and that interest rates tend to lead output growth.
Because we allow for these four types of firms to coexist, our model nests many price-setting models considered in the literature. First, sticky-price models are frequently augmented with rule-of-thumb firms to better match the inflation inertia observed in the data, but the relative importance of forward looking versus backward-looking behavior has been much debated.
Our result that sticky-price firms play a predominant role is consistent with the findings of much of this literature, but also points to important roles for both flexible-price full-information firms and sticky-information firms. It also raises the possibility that the role previously assigned to rule-of-thumb firms in explaining backward-looking behavior in the New Keynesian Phillips Curve (NKPC) could instead be accounted for by the presence of sticky-information firms. Specifically, we show that in the presence of strategic interaction, the behavior of rule-of-thumb and sticky-information firms is similar and one can erroneously classify rule-of-thumb firms as sticky information firms and viceversa. When we eliminate rule-of-thumb firms from the model, the estimated share of sticky information firms rises to twenty-five percent, essentially absorbing the fraction previously assigned to rule-of-thumb firms.
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