Corina Boar, New York University & Federal Reserve Bank

Nonlinear Inflation Dynamics in Menu Cost Economies

with Andres Blanco, Callum Jones, Virgiliu Midrigan

We show that canonical menu cost models, when parameterized to match the distribution of price changes, suffer three important shortcomings: they require implausibly large menu costs, they predict a large amount of misallocation, and they cannot reproduce the comovement between the frequency of price changes and inflation in the data. These shortcomings are amplified in the presence of microeconomic strategic complementarities. We resolve them by extending the standard multi-product menu cost model along two dimensions. First, we assume that strategic complementarities are at the firm, not the product level. Second, we assume that the products sold by a firm are imperfect substitutes. In contrast to standard models, the frequency of price changes increases rapidly with the size of monetary shocks, so our model implies non-linear output responses. Even for small shocks, our model predicts stronger selection effects and therefore more flexible price responses and smaller real effects.