In Search of Price Rigidities (Recent Sector Evidence from Argentina)

Abstract

Monetary and exchange rate policies have different effects on relative prices among economic sectors - and thus significantly influence the real side of the economy.

The hypothesis that the price adjustment to nominal shocks is instantaneous has been part of the monetarist approach explaining the inflationary process in Argentina.

But Morisset and Revoredo argue that monetary and exchange rate policies have had different effects on relative prices and thus have a significant influence on the real side of the economy. The existence of rigidities has prevented full and instantaneous price adjustments.

Recent work on inflation in imperfectly competitive markets explains rigidities as a consequence of firms' strategic responses to nominal shocks, which in turn depend on the market structure and demand elasticities faced by firms.

Price rigidities emerge when firms facing changes in aggregate demand behave collusively, and there are costs for customers to switch between suppliers. The higher the collusive behavior, the higher the possibility for these firms to maintain or eventually increase their prices during recession. In contrast, when the costs for customers to switch between suppliers are low, firms are obliged to adjust their prices to new demand conditions, otherwise they will lose their customers.

Changes in foreign prices affect domestic prices depending on the degree of foreign competition and the price formation mechanism in each sector. As expected, price rigidities are minimal in tradable sectors where firms react to these changes by changing their prices almost instantaneously (although not one-for-one). The response in nontradable activities depends on indirect effects and whether prices are indexed to a foreign currency, likely when transactions are conducted in a foreign currency.

Because understanding this is essential for effective policymaking, Morisset and Revoredo analyze price behavior of four economic sectors - agriculture, industry, (retail) commerce, and services - in Argentina from 1981 - 94. (The two nontradable sectors account for most GDP and employment in Argentina.)

The econometric analysis shows large differences in the price behavior across sectors. Firms do not respond uniformly to changes in production costs, foreign prices, and demand conditions.

The conclusions have obvious policy implications. The response of individual prices reflects the distribution of adjustment costs across sectors in the case of nominal shocks. This is most evident when, facing a recession, some sectors are able to maintain their margins through collusive behavior, while others have to reduce them to retain their customers. To maintain social and political stability, the government's challenge is to minimize divergence across sectors. Increasing competition appears to be a crucial element of this strategy since monopolistic power is frequently associated with the existence of price rigidities.

This paper - a product of the Country Operations Division, Country Department I, Latin America and the Caribbean - is part of a larger effort in the department to understand goods and services market behavior in developing countries.