Search, Costly Price Adjustment and the Frequency of Price Changes Theory and Evidence

We establish a new empirical finding that the intensity of search for the best price affects the frequency of nominal price changes. This relationship holds in very different economies and for various proxies for search intensity. We show that it can be derived from a simple model of monopolistically competitive firms that face menu costs of changing nominal prices and heterogeneous consumers who search for the best price. We discuss several alternative explanations and argue that, with one exception, they cannot explain the observed correlations. The implied cross-sectional test of the menu cost model provides a potential explanation of the rejections of the menu cost model in some time-series tests. Our results imply that in macroeconomic, general equilibrium models, in which nominal rigidity is based on the CalvoTaylor framework, the frequency of price changes should be treated as an endogenous parameter. We would like to thank Mario Bonomo, Mathias Dewatripoint, Jordi Galí, Paul Romer and Julio Rotemberg for very helpful comments and Andrei Chernyak and Michelle Lin for excellent research assistance. The first author would like to thank the European Center of Advanced Research in Economics and Statistics (ECARES), Université Libre, Brussels, Belgium, where part of this work was done, for its hospitality and acknowledges financial support from Social Sciences and Humanities Research Council of Canada, grant # 410-96-0245.