Date of Original Version
European Economic Review Volume 52, Issue 8, November 2008, Pages 1480-1493
Abstract or Table of Contents
This paper compares the P-bar model of price adjustment with the currently dominant Calvo specification. Theoretically, the P-bar model is more attractive as it depends on adjustment costs for physical quantities rather than nominal prices, while incorporating a one-period information lag. Furthermore, the resulting adjustment relation is more completely free of “money illusion,” in terms of dynamic relationships, and therefore satisfies the natural-rate hypothesis of Lucas [1972a. Econometric testing of the natural rate hypothesis. In: Eckstein, O. (Ed.), The Econometrics of Price Determination. Board of Governors of the Federal Reserve System], which is not satisfied by the Calvo model in any of its variants. Along the way, it shows that both the P-bar and Calvo models can be formulated in distinct versions in which current real wages are, or are not, allocative. Quantitatively, for a given calibration of the demand parameters, the implied time-series properties of the inflation rate, output gap, and nominal interest rate are determined for various policy parameters, and are compared with quarterly data for the US economy. Neither model dominates but, overall, the comparison seems somewhat more favorable to the P-bar model and certainly does not provide support for the dominant position held by the Calvo model in current monetary policy analysis.