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Inflation Asymmetry, Menu Costs and Aggregation Bias - A Further Case for State Dependent Pricing (with Adam Reiff)

Asymmetric inflation response to aggregate shocks is an identifying macro-prediction of state dependent pricing models with trend inflation (Ball and Mankiw, 1994). The paper uses the natural experiment of symmetric value-added tax (VAT) changes in Hungary with highly asymmetric inflation responses to provide further evidence for state-dependent pricing and for the Ball-Mankiw conjecture.
The paper shows, furthermore, that while a standard menu cost model like that of Golosov and Lucas (2007) underestimates the observed asymmetry, a model of multi-product firms that takes sectoral heterogeneity explicitly into consideration can quantitatively account for the inflation asymmetry observed in the data. This aggregation bias of the standard model is the result of the strong interaction term between trend inflation and menu costs in determining asymmetry in the model, and the positive correlation between sectoral inflation rates and menu costs in the data. The paper implies that the real effects of negative monetary shocks can be substantial even in the standard Golosov and Lucas (2007) model if these additional factors are taken into consideration.
 

A Spatial Explanation for the Balassa-Samuelson Effect (with Miklos Koren)

We propose a simple spatial model to explain why the price level is higher in rich countries. There are two sectors: manufacturing, which is freely tradable, and non-tradable services, which have to locate near customers in big cities. As countries develop, total factor productivity increases simultaneously in both sectors. However, because services compete with the population for scarce land, labor productivity will grow slower in services than in manufacturing. Services become more expensive, and the aggregate price level becomes higher. The model hence provides a theoretical foundation for the Balassa-Samuelson assumption that productivity growth is slower in the non-tradable sector than in the tradable sector. Empirical results confirm two key implications of the theory. First, we compare countries where land is scarce (densely populated, highly urban countries) to rural countries. The Balassa-Samuelson effect is stronger among urban countries. Second, we compare sectors that locate at different distance to consumers. The Balassa-Samuelson effect is stronger within sectors that locate closer to consumers.

A Model of Unconventional Monetary Policy (with Mark Gertler)

The paper develops a quantitative monetary DSGE model that allows for financial intermediaries that face endogenous balance sheet constraints. It uses the model to simulate a crisis that has some basic features of the current economic downturn. The model, then is used to quantitatively assess the effect of direct central bank intermediation of private lending, which is the essence of the unconventional monetary policy that the Federal Reserve has developed to combat the subprime crisis. It is shown numerically how central bank credit policy might help moderate the simulated crisis. Then the optimal degree of central bank credit intervention and the welfare gains are calculated in this scenario.