Menu Costs and Markov Inflation:
A Theoretical Revision with New Evidence
Working Paper No. 06-W10
Christian Ahlin and Mototsugu Shintani
ABSTRACT [article]
We revisit a foundational theoretical paper in the menu cost literature, Sheshinski and Weiss (1983), one of the few to treat stochastic inflation
with persistent deviations from trend. In contrast to the original finding,
we find that optimal pricing in this environment entails using different
(s,S) bands in high-inflation and low-inflation states of the world. The
low-inflation band is strictly contained within the high-inflation band.
This revised solution has very different implications from the original one.
Firms are generally risk-loving, not risk-averse, with respect to inflation.
An increase in the variance of inflation increases price dispersion when
inflation is high and decreases price dispersion when inflation is low. On
an aggregate level, this optimal pricing would lead to bunching of prices
and non-neutrality of money in the setting of Caplin and Spulber (1987). To
test the main finding, we construct an establishment-level dataset from the
months surrounding Mexico's Tequila crisis, in 1995. In the high-inflation
state, price increases are larger and establishments allow their prices to
vary more widely around their respective long-run mean relative prices.
Cross-establishment price dispersion is lower, but this result seems due to
decreased establishment heterogeneity rather than narrower (s,S) bands.
Overall, the evidence suggests that establishments employ wider (s,S) bands
in the high-inflation state.
Keywords and Phrases: (s,S) policy, neutrality of money, optimal pricing, regime switching
JEL Classification Number: D40, E31