BIS paper develops tractable menu cost model with aggregate markup drift
A new Bank for International Settlements (BIS) working paper extends the menu cost model by introducing a drift in the aggregate markup. The model analytically characterizes firms' value function and markup distribution, making impulse response calculations as easy as in conventional New Keynesian models.
Extending the menu cost framework
This paper extends the Gertler and Leahy (2008) menu cost model by introducing a negative drift in the aggregate markup, consistent with moderate and positive trend inflation.
This innovation allows for an analytical characterization of firms' value function and markup distribution.
The model derives explicit equations sufficient to close the general equilibrium, simplifying the calculation of impulse responses to aggregate shocks, making it as straightforward as in conventional representative-agent New Keynesian DSGE models.
Furthermore, the model replicates the empirically observed positive correlation between the inflation rate and the frequency of price changes, a feature absent in the zero trend inflation case analyzed by Gertler and Leahy.
Asymmetry drives price flexibility
The model's key results stem from two mechanisms: the asymmetry of the policy rule and the markup distribution, both linked to the negative aggregate markup drift.
The expected negative drift creates asymmetry in the policy rule, making markup thresholds more responsive to aggregate shocks and enhancing aggregate price flexibility.
This historical drift also leads to an asymmetric markup distribution, with more firms accumulating near the lower threshold.
Consequently, inflationary shocks expand the number of firms increasing prices more than those decreasing prices, further boosting price flexibility.
Bridging theory and empirics
This paper significantly advances menu cost modeling by achieving analytical tractability while incorporating empirically relevant features.
Its explicit Phillips curve, with heightened responsiveness to shocks, offers a more nuanced understanding of inflation dynamics than previous models.
Consequently, the research provides a valuable tool for central banks to better analyze monetary policy transmission in a world with positive trend inflation.