Menu Costs, Calvo Fairy, Inflation and Micro Facts

This paper investigates whether extensions of the Calvo and menu-cost models that include idiosyncratic technology shocks are consistent with key features of individual consumer price adjustment. The comparison of the models focuses on three facts pertaining to the impact of inflation on the setting of consumer prices. First, the average frequency of consumer price changes initially rises slowly with the level of inflation, becoming more responsive when annual inflation gets beyond 10-15 percent. Second, at low levels of inflation, the distribution of price changes contains a large number of both small and large price increases and decreases. When inflation is high, most price changes are positive, and their distribution continues to be spread out. Third, the average magnitude of price increases and decreases varies little with the duration of price spells. The menu-cost model is consistent with the first and third facts, but the Calvo model, while inconsistent with these two facts, provides a much better fit of the distribution of price changes. JEL classification: E31, D40.