International Finance Discussion Papers (IFDP)
Price Setting and Volatility: Evidence from Oil Price Volatility Shocks
How do changes in aggregate volatility alter the impulse response of output to monetary policy? To analyze this question, I study whether individual prices in Producer Price Index micro data are more likely to change and to move in the same direction when aggregate volatility is high, which would increase aggregate price exibility and reduce the effectiveness of monetary policy. Taking advantage of plausibly exogenous oil price volatility shocks and heterogeneity in oil usage across industries, I find that price changes are more dispersed and less frequent, implying that prices are less likely to move in the same direction when aggregate volatility is high. This contrasts with findings in the literature about idiosyncratic volatility. I use a state-dependent pricing model to interpret my findings. Random menu costs are necessary for the model to match the positive empirical relationship between oil price volatility and price change dispersion. This is the case because random menu costs reduce the extent to which firms with prices far from their optimum all act in a coordinated fashion when volatility increases. The model implies that increases in aggregate volatility do not substantially reduce the ability of monetary policy to stimulate output.
Keywords: Volatility, Ss model, Menu cost, Monetary policy, Oil
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