OPEN-ECONOMY MARKET: Price Adjustment

We defer discussion of this until the next section, other than to note that, in common with other general equilibrium models that use Dixit-Stiglitz aggregation (such as Ireland [1997]), our model has the property that under price flexibility, the markup (Л, /£,) is constant, and equal to 0/(0-1).
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where st = log St. Our analysis treats Rt*, Ap,* andyt* as exogenous variables. To complete the model, we need to specify laws of motion for these variables as well as the other exogenous processes Ah к,, and v,. We specify these processes in Section 6. We also need a domestic policy rule for Rt or A/,; in this paper we consider a variety of alternative rules for Rh as will be discussed in Section 8. Finally, we need to specify price adjustment behavior, a task to which we now turn.

Price Adjustment

The Р-Bar Model

The typical household has one more choice other than those we have already analyzed, namely its choice of Pt, the price that it charges for its output. This section analyzes this decision and thereby introduces our specification of price adjustment. Since the adjustments are gradual, our model belongs to the general category discussed recently by Goodfriend and King (1997).
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where yi > 0. Output is thus costly to adjust, with the adjustment cost measured in terms of (yt+J-y the log of output relative to capacity. Expressing costs in terms of this variable, instead of yt+j, reflects the notion that output adjustment costs principally arise from the implied changes the producer must make in the level of employment of labor input. Changes inyt that are matched by a corresponding change in у , are unlikely to be associated with such costly changes in labor input,

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