European Economic Review · 2000 · 1.3K citations · 31 references
Social SciencesBusiness EconomicsEconomicsMacroeconomicsMicroeconomicsMonetary EconomicsDynamic Economic ModelsInflation PolicyMonetary PolicyMonetary Transmission MechanismFirm-level Price DynamicsInflation DynamicsInflation Pass-throughMonetary Policy DynamicsPricing Power
A recent decline in firms’ pass‑through of cost changes, linked to lower inflation, has reduced their pricing power and has important implications for monetary policy. The paper argues that the low inflation environment itself drives the decline in pass‑through. Using a micro‑price‑setting model, the authors show that lower perceived persistence of cost changes reduces pass‑through, and an economy‑wide model illustrates how this shift alters output and inflation dynamics. Empirical evidence shows that inflation is positively correlated with its persistence, implying that low inflation causes low pass‑through, and that such effects can vanish rapidly if monetary policy or expectations shift.
Recently there has been a significant decline in the degree to which firms 'pass through' changes in costs to prices, a decline that is frequently characterized as a reduction in the 'pricing power' of firms. The decline appears to be associated with the decline in inflation in many countries. The decline has important implications for monetary policy because it affects both forecasts of inflation and the effects of changes in monetary policy on inflation. Some have argued that the decline in pricing power helped to keep inflation low in the face of apparently strong demand pressures in the United States in the late 1990s. This paper puts forth the view that the decline in pass-through or pricing power is due to the low inflation environment that has recently been achieved in many countries. First, a microeconomic model of price setting is used to show that lower pass-through is caused by lower perceived persistence of cost changes. Evidence is then presented showing that inflation is positively correlated with persistence of inflation, suggesting that the low inflation itself has caused the low pass-through. An economy-wide model consistent with the micromodel is then presented to illustrate how such changes in pricing power affect output and inflation dynamics in favorable ways, but can disappear quickly if monetary policy and expectations change.
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