Menu Costs and Asymmetric Price Adjustment

We study optimal price setting by a monopolist in an in…nite horizon model with stochastic costs, moderate in‡ation, and costly price adjustment. For realistic parameters, chosen to replicate observed frequencies of price changes, the model …ts numerically several empirical regularities. In particular, price reductions are larger but less frequent than price increases, and prices respond considerably faster to cost increases than to cost decreases. The associated kink in the steady state short-run Phillips curve implies that the output loss associated with a small negative in‡ation surprise is about twice as large as the output gain associated with a small positive in‡ation surprise. Keywords: Asymmetric price adjustment, downward rigidity, menu costs, Phillips curve. JEL Codes: D42, E31, E32. Department of Economics, Stockholm School of Economics, Box 6501, SE–113 83 Stockholm, Sweden. Email: [email protected]. Department of Economics, Stockholm School of Economics, Box 6501, SE–113 83 Stockholm, Sweden. Email: [email protected]. Institute for International Economic Studies, Stockholm University, SE–106 91 Stockholm. Financial support from Torsten and Ragnar Söderbergs Stiftelse (Ellingsen) and the Hedelius travel grant (Friberg) is gratefully acknowledged. Part of this research was carried out during Friberg’s visit to Princeton University, for whose hospitality he is deeply grateful. We thank Alan Blinder, Mark Gertler, Sam Pelzman and Elu von Thadden for helpful discussions and comments. The paper has also bene…ted from the comments of seminar participants at the Carlos III, the CIE Industrial Organization workshop in Århus 2005, IIES, Research Institute of Industrial Economics in Stockholm, Stockholm School of Economics, Stockholm University, Toulouse University, Uppsala University, and the 2004 ENTER jamboree (Barcelona). Remaining errors are ours.