PRICE AND OUTPUT DYNAMICS: MICROFOUNDATIONS, TIMING, AND TRANSMISSION

DARRELL FRANKLIN PARKER, Purdue University

Abstract

Demand shocks and cost shocks are commonly thought to take considerable time to "work through the system". With only one stage of production, as in most macro models, the transmission links are severely limited. A richer specification, with additional potential delays in impact, can be modeled by postulating price - and output - setting firms at different stages of production, each responding to the information it receives. A two-stage model of optimizing firms provides behavioral hypotheses for inclusion in a multi-sector equilibrium macro model. Within such a framework price and output movements need not be synchronized. This focus on the transmission of shocks provides a reinterpretation of the link between price and output, an emphasis on the expected duration of changes, and implications on the usefulness of policy tools in changing the short-run adjustment path of an economy. Traditionally, stories of price and output moving together have focused on demand shocks. This analysis suggests it is appropriate to consider anticipation of cost changes as also yielding this type of behavior. The patterns of movement in other variables will be different however. Notably inventories will increase prior to a price increase in anticipation of higher production costs. With demand shocks, final inventories do not lead price changes positively. The expected duration of shocks is found to determine whether the firm's response includes both prices and output changes. Unanticipated shocks known to be transitory do not change future expectations, and thus, will not change prices, only quantities change. Unanticipated shocks which need not be transitory shift future expectations and do have price effects, as well as output effects. An unanticipated demand movement does have short run effects. This suggests that a monetary authority can have real effects. Those agents with better information are able to respond early. Thus, potentially the authority can induce behavior consistent with its objectives. It is also seen that the time necessary to adjust after some types of cost shocks is actually reduced by the intervention of a monetary authority. Also, the ability of some (but not all) agents to anticipate the policy shift can increase the effectiveness of the policy instrument.

Degree

Ph.D.

Subject Area

Economics

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