PDF Ebook Do Flexible Durable Goods Prices Undermine Sticky Price Models?
Modern theories of the monetary business cycle typically attribute central importance to nominal rigidities. Much of our understanding of the behavior of sticky price models has come from one-sector models with symmetric firms using identical price setting rules. In realistic economies, however, not all prices are equally sticky. For instance, the price of a bottle of Coca Cola was stuck at fivecents for a period of 70 years.1 At the other extreme, the prices of many agricultural commodities vary daily. We will make the case that the pricing of newly constructed housing is better characterized as flexible than as sticky in the sense required for/by the logic of the modern sticky price model.
In addition to restricting their attention to models in which all prices are equally sticky, a surprising fraction of researchers focus on the behavior of non durables alone. Yet in actual data, fluctuations in the production of durable goods are a prominent feature of the response to monetary shocks. For example, in the data, housing production falls sharply following a monetary contraction, while the production of non durables falls very little.
This paper studies the equilibrium implications of the interaction between the degree of durability and the degree of price flexibility in a sector. In particular, we ask whether sticky price models can have sectors with flexible prices and still match the main features of the data. We analyze a model with both sticky price and flexible price sectors, and with both durable and nondurable goods. We find that it is not sufficient to specify how large the sticky price sector is relative to the flexible price sector; it matters crucially which sectors have sticky prices.
In particular, neoclassical sticky price models exhibit surprising behavior when augmented with durable goods with flexible prices. In these models there is a strong tendency for production of flexibly priced durables to expand during periods of tight money and contract during periods of monetary expansion. In an instructive special case in which the only sticky prices are those of nondurables, the negative co movement of durables and non durables output entails exactly offsetting effects, and the behavior of aggregate output in the model is very similar to that of a model with fully flexible prices. While this neutrality result requires special circumstances, the perverse response of flexibly priced durables to monetary policy is highly robust.
What is special about durables? Purchases of non durables are subject to the consumption smoothing logic of the permanent income hypothesis. As a result, there is relatively little room for consumers to substitute inter temporally in response to a change in the relative price of non durables. On the other hand, the stock – and the associated shadow value – of durables is nearly constant over the modest horizon for which monetary disturbances might have real effects; the inter temporal elasticity of substitution for purchases of durables is nearly infinite. The result is that a small, temporary increase in the relative price of durables causes a large shift of expenditure away from that sector.
Monetary expansions increase spending at constant prices, and typically result in increased output, increased factor demands, and higher marginal costs of production. To the extent that monetary expansions increase output and employment in equilibrium, the period following such an expansion is an expensive time to produce. While the markups on goods with sticky prices are squeezed below their desired levels, for producers in flexible price sectors, the increase in factor prices is merely an adverse cost shock. Unless there is an offsetting endogenous increase in demand, flexible price sectors will contract. We show that there is little hope of generating such an increase in the demand for durables as a consequence of monetary expansion. This scenario contrasts sharply with the conventional view of durables in informal Keynesian models. Those models posit powerful forces that cause demand for durables to rise sharply following a monetary expansion, more than offsetting any contractionary effects of increased factor prices.
The mechanism that leads to the contrarian behavior of the durables sector in our scenario is a manifestation of a more general comovement problem discussed by Murphy, Shleifer, and Vishny [1989]. In multi-sector general equilibrium models, shocks that cause an expansion in one sector have a tendency to cause contractions in other sectors. For example, in a real business cycle model, temporary favorable technology shocks in the consumption sector also cause a contraction in the durables sector and tend not to raise aggregate output. The logic is essentially the same; temporary technology shocks are analogous to the temporary deviations in the markup (or “real marginal cost”) in the sticky price model.
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PDF Ebook Do Flexible Durable Goods Prices Undermine Sticky Price Models?
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