CMSA Colloquium: Menu Costs and the Volatility of Inflation

We present a state-dependent equilibrium pricing model that generates inflation rate fluctuations from idiosyncratic shocks to the cost of price changes of individual firms.  A firm's nominal price increase lowers other firms' relative prices, thereby inducing further nominal price increases. We first study a mean-field limit where the equilibrium is characterized by a variational inequality and exhibits a constant rate of inflation. We use the limit model to show that in the presence of a large but finite number n of firms the snowball effect of repricing causes fluctuations to the aggregate price level  and these fluctuations converge to zero slowly as n grows. The fluctuations caused by this mechanism are larger when the density of firms at the repricing threshold is high, and the density at the threshold is high when the trend inflation level is high. However a calibration to US data shows that this mechanism is quantitatively important even at modest levels of trend inflation and  can account for the positive relationship between inflation level and volatility that has been observed empirically.

(Joint with Makoto Nirei, University of Tokyo.)