Repricing Avalanches

Abstract

We present a menu-cost pricing model with a large but finite number n of firms. A firm's nominal price increase lowers other firms' relative prices, thereby inducing further nominal price increases. The distribution of these repricing avalanches converges, as n increases to infinity, to a mixture of Generalized Poisson Distributions (GPD) with an index of dispersion equal to 1/(1-theta)^2, where theta is determined by the equilibrium of the continuous limit. We calibrate the model to the U.S. experience during 1988-2005 and obtain a theta surprisingly close to unity. Simulations show that a GPD fits well the distribution of avalanches but that, once we account for the dynamics, the multiplier effect derived from a firm adjusting prices by paying menu costs is even larger. We also show that the model can account for the positive relationship between inflation level and volatility that was observed in 1988-2005 in the U.S.

Keywords: State-dependent pricing, menu costs, strategic complementarity, inflation volatility, aggregate fluctuations, self-organized criticality, Generalized Poisson distribution

JEL Classification: E31