Precautionary price stickiness: Bank of Spain paper

In a Bank of Spain working paper titled Precautionary Price Stickiness, authors James Costain and Anton Nakov propose two models in which price stickiness arises endogenously even though firms are free to change their prices at zero physical cost.

"Firms are subject to idiosyncratic and aggregate shocks, and they also face a risk of making errors when they set their prices," they write.

In the first specification, firms are assumed to play a dynamic logit equilibrium, which implies that big mistakes are less likely than small ones. The second model derives logit behaviour from an assumption that precision is costly.

The empirical implications of the two models are very similar. "Since firms making sufficiently large errors choose to adjust, both versions generate a strong ‘selection effect' in response to a nominal shock that eliminates most of the monetary non-neutrality found in the Calvo model," says the paper. Thus, the model implies that money shocks have little impact on the real economy.

Click here to read the paper.