Chancellors and central bankers face a perennial headache: booms typically cause inflation, while recessions mainly reduce output without reducing prices or inflation. New ESRC-funded research by Professor V Bhaskar of the University of Essex explains how this problem emerges through the phenomenon of 'asymmetric price adjustment' – the fact that firms are far quicker to increase prices than to cut them.
This work has important implications for inflation targeting by the Bank of England and other central banks. The Nobel Laureate Robert Lucas has recently argued that the optimal inflation target may be negative, so that central banks may need to deflate the economy persistently. But Bhaskar's research on pricing asymmetries shows that deflation would aggravate the negative effects on output and employment considerably.
Positive inflation has the effect of raising output, since it prevents the output and employment losses due to price asymmetries. On the other hand, the inflation target for the central bank should not be too high, since the output gains are relatively modest.
'Firms are quick to raise prices when their costs increase, but not so keen to reduce prices when their costs fall.'
Talk to a non-economist, and you would probably get 80 per cent agreeing with this statement. Ask an economist, and you would probably get a more sceptical response. That is, until recently, after a wide range of careful empirical studies have shown that non-economists are indeed correct in their suspicions.
The economist's scepticism is warranted since asymmetric price adjustment is a puzzle. Although monopoly power on the part of firms or retailers is often advanced as an explanation, it is not a very good one. Monopoly producers will choose their best price, and this moves symmetrically, in line with costs.
This research provides an explanation for price asymmetry based on limited monopoly power. Bhaskar argues that in most markets, sellers have some monopoly power, but this is circumscribed by competition. Asymmetric price adjustment allows sellers to keep prices as high as possible, within the constraints imposed by competition.
Although asymmetric adjustment makes for higher prices, the research also identifies a countervailing force. Since firm's prices will, on average, be too high when they do not adjust their price, firms will find it optimal to choose lower prices when they do adjust price. This mitigates some of the consequences of asymmetric adjustment.
Nevertheless, prices on average will be higher. Consequently, the level of output in the economy as a whole will be lower and unemployment will be higher. Bhaskar quantifies the effect and show that while there is an output loss, it is relatively modest: for the UK economy, it is the equivalent of £1.3 billion per year, or £20 for every man, woman and child.
### For further information, contact Professor V. Bhaskar on 01206-872744 or email: vbhas at essex.ac.uk; homepage: http://privatewww.essex.ac.uk/~vbhas/ or Iain Stewart or Lesley Lilley at ESRC, on 01793-413032-413119 or email: iain.stewart at esrc.ac.uk or iain.stewart at esrc.ac.uk.
The full study, 'Asymmetric Price Adjustment: Microfoundations and Macroeconomic Implications', Discussion Paper 547, Department of Economics, University of Essex is available at: http://www.essex.ac.uk/economics/discussion-papers/papers-text/dp547.pdf
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