Please use this identifier to cite or link to this item: http://scholarbank.nus.edu.sg/handle/10635/30719
Title: Inflation Targeting, Price Stickiness And Price Adjustment Speed
Authors: WAQAS AHMED
Keywords: Long Run Inflation, Price Stickiness, Steady State, Inflation-Output Trade-off, Endogenous Price Adjustment Speed, Menu Cost
Issue Date: 26-Apr-2011
Source: WAQAS AHMED (2011-04-26). Inflation Targeting, Price Stickiness And Price Adjustment Speed. ScholarBank@NUS Repository.
Abstract: The convenient tractability and reasonable short run performance of time dependent pricing models are their main motivations for use in so many macroeconomic models. There are two types of such time depended models which are more common among the researchers, i.e., Calvo pricing models and Taylor pricing models. Calvo pricing models are continuous in nature whereas the Taylor pricing models are discrete. Standard practice, of these models, is to use fixed price adjustment probability over time. This is a reasonable assumption as under neo-Keynesian setup there can be short run effects of changes in inflation in the presence of nominal rigidities and it has empirical backing too. The objective of this thesis is to find out if these, easy and useful, time dependent models are theoretically and empirically sound in the long run under the neo-Keynesian setup as well. The first chapter develops a simple model with nominal price rigidity in the form of Calvo pricing and shows that the empirically and theoretically propagated long run evidence on existence of natural rate hypothesis is missed by the model. The model tends to satisfy the natural rate hypothesis when the price adjustment speed is allowed to move monotonically with the long run inflation level. However, such endogeneity of price adjustment speed is achieved in a restrictive manner, i.e., by exogeneizing the output at its steady state level which seemed to be the best instrument as compared to other options available in our simple setup. The first chapter is linked to the second chapter which relaxes the fixed output condition by introducing the fixed price adjustment cost. The price adjustment cost has been calculated to be even less than 1 percent of the total cost of production. This modification has helped in making the long run results from our model much in line with the long run evidence on existence of natural rate hypothesis. The minor differences can be explained by the existence of the principle of near rationality. Our main finding from Calvo pricing models of chapter 1 and 2 is to target a minor level of long run inflation is the optimal policy in the case of USA. However, when we calibrate our models for Pakistan, a developing country with much more monopolistic element as compared to, we find that targeting zero level of long run inflation is the best solution. Doing so keeps the monopolistic element in check as firms find no incentive to hike up the prices. The third chapter deals with Taylor pricing in its actual discrete form. The same procedure is adopted as in the case of the first two chapters. Taylor pricing contracts are compared with the Calvo pricing probability using the Dixon-Kara framework instead of the standard procedure which leads to miss-specification. The results show that endogeneity of pricing contracts lead to satisfaction of natural rate hypothesis in the near rationality sense, however, there is a good degree of inertia in Taylor pricing contracts as compared to Calvo price adjustment probability at high levels of long run inflation. The fourth chapter breaks away from the standard literature, as in the first three chapters, on time dependent models and tries to utilize price setting distributions across a cross section of firms. In response to a nominal shock the price adjustment speed is allowed to change every period of time as well as over the cross section of firms. The only restriction is the assumed distribution of price adjustment speed. The results show that when an unbiased distribution is followed convergence of real variables to the steady state is relatively faster.
URI: http://scholarbank.nus.edu.sg/handle/10635/30719
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