Adapting Prices or Quantities in the Presence of Adjustment Costs?

Abstract

It is often hypothesized that costs of adjusting both price and quantities may have important implications for the macroeconomic adjustment process, not least to nominal shocks. We analyse this in an explicit intertemporal general equilibrium model considering the empirically relevant case of fixed costs of adjusting prices and fixed and variable costs of adjusting quantities. We find that the presence of both price and quantity adjustment costs changes the response to shocks significantly. It is an implication that "small" shocks do not support the "menu-cost case" but rather both fixed prices and quantities (rationing). A numerical analysis based on available evidence on adjustment costs is used to illustrate the likelihood that the various adjustment patterns actually arise.

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