Low in#ation, pass-through, and the pricing power of "rms

Recently there has been a signi"cant decline in the degree to which "rms &pass through' changes in costs to prices, a decline that is frequently characterized as a reduction in the &pricing power' of "rms. The decline appears to be associated with the decline in in#ation in many countries. The decline has important implications for monetary policy because it a!ects both forecasts of in#ation and the e!ects of changes in monetary policy on in#ation. Some have argued that the decline in pricing power helped to keep in#ation low in the face of apparently strong demand pressures in the United States in the late 1990s. This paper puts forth the view that the decline in pass-through or pricing power is due to the low in#ation environment that has recently been achieved in many countries. First, a microeconomic model of price setting is used to show that lower pass-through is caused by lower perceived persistence of cost changes. Evidence is then presented showing that in#ation is positively correlated with persistence of in#ation, suggesting that the low in#ation itself has caused the low pass-through. An economy-wide model consistent with the micromodel is then presented to illustrate how such changes in pricing power a!ect output and in#ation dynamics in favorable ways, but can disappear quickly if monetary policy and expectations change. ( 2000 Elsevier Science B.V. All rights reserved. JEL classixcation: E31; E52; F41