Explaining hump-shaped inflation responses to monetary policy shocks

According to conventional wisdom, the output effects of a monetary policy shock commence within months of the shock, while most inflationary effects lag significantly. We demonstrate a simple model that can explain the conventional wisdom and is consistent with profit maximizing price setting decisi...

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Bibliographic Details
Published in:Managerial and decision economics 2007-09, Vol.28 (6), p.605-617
Main Author: Yetman, James
Format: Article
Language:English
Subjects:
Aggregate demand
Economic modeling
Economic models
Empirical evidence
Inflation
Inflation shocks
Inflexible prices
Menu costs
Monetary policy
Price level changes
Price shocks
Prices
Studies
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Summary:According to conventional wisdom, the output effects of a monetary policy shock commence within months of the shock, while most inflationary effects lag significantly. We demonstrate a simple model that can explain the conventional wisdom and is consistent with profit maximizing price setting decisions by firms, based on the assumption that renegotiating existing contracts is costly. Thus, firms jointly choose both their price and the expected length of time for which that price will hold each time they re-contract. We show that such a 'sticky contracting' assumption, combined with menu costs, generates a hump-shaped inflation response to monetary policy shocks.
ISSN:0143-6570
1099-1468
DOI:10.1002/mde.1326