The Benchmark Specification

Figure 1.8 displays impulse responses of the variables included in the SVAR to a contractionary monetary policy shock that is identified according to the iden- tification scheme described in the last section. In the figure, the inner solid lines denote the median impulse responses identified from a Bayesian vector- autoregression with 1000 draws using sign restrictions, while the shaded areas indicate the 16% and 84% percentiles of the posterior distribution of the impulse responses.27 _{The dashed vertical lines mark the end of the restriction horizon,} which is 12 months for the benchmark regression. The red dashed lines addition- ally show the impulse responses generated by the one model that is closest to the median over all 1000 draws. It can be seen that generally, the impulse responses generated by this “close-to-median” model are quite similar to the median over all models, so our results are robust to this adjustment. Since the signs of the responses of industrial production, the producer price index as well as the Euri-

27_{Under the assumption of normality, these percentiles correspond to one-standard error}

bands, see Uhlig (2005). Reporting one-standard error confidence bands is a standard approach in the literature.

bor have been restricted, there is no need to extensively interpret the direction of these adjustments. As preset, industrial production falls as a reaction to the shock. Similarly, the producer price index falls by about 0.25% and stays below benchmark for about two years. As specified, the Euribor increases and remains above baseline somewhat longer than restricted. To evaluate the response of the size and frequency of price adjustment separately, we leave the extensive and intensive margins unrestricted. Figure 1.8 shows that the extensive margin increases significantly following the shock and reaches its maximum cumulative response of around 4 percentage points after two years. The direction of the response is as expected; the fraction of firms that decides to adjust prices rises. The increase is temporary; after around three years the cumulative response be- comes insignificant.

Figure 1.8: Impulse Responses to a Monetary Shock

Notes: The black lines denote the median of the impulse responses following a contractionary monetary shock, the red dotted lines indicate the “close-to-median” model, and the shaded areas indicate the 16% and 84% percentiles of the posterior distribution of the responses. Impulse responses are identified from a BVAR (1000 draws) using sign restrictions with a restriction horizon of 12 months. The impulse responses of industrial production, the PPI and the Euribor are changes in (log) levels of the variables, impulse responses of the IM and EM are cumulative responses.

As expected, the average size of price adjustment, the intensive margin, decreases following a contractionary monetary shock; the maximum cumulative response amounts to around -0.25 percentage points after about three years.

Figures 1.9 and 1.10 show the impulse responses to business cycle disturbances that have been explicitly identified to disentangle the monetary shock from ag- gregate supply and demand shocks. Moreover, the response of the extensive margin to shocks to the real economy are of course interesting in itself indicat- ing whether the frequency of price adjustment responds to aggregate economic shocks next to monetary policy shocks. Figure 1.9 reveals that the extensive margin clearly responds to a positive demand shock; the cumulative response is significant and strong amounting to more than 10 percentage points after about two and a half years. Moreover, as expected, the intensive margin increases as well. By contrast, a positive supply shock does not have a significant effect on the extensive margin, while the response of the intensive margin is weak and significant for a few periods only, as Figure 1.10 shows.

Figure 1.9: Impulse Responses to a Demand Shock

Notes: The black lines denote the median of the impulse responses following a positive demand shock, the red dotted lines indicate the ”close-to-median” model, and the shaded areas indicate the 16% and 84% percentiles of the posterior distribution of the responses. Impulse responses are identified from a BVAR (1000 draws) using sign restrictions with a restriction horizon of 12 months. The impulse responses of industrial

production, the PPI and the Euribor are changes in (log) levels of the variables, impulse responses of the IM and EM are cumulative responses.

Overall, however, the significant and relatively strong reaction of the extensive margin to a monetary policy shock as well as to an aggregate demand disturbance clearly contradicts the implications of time-dependent models that the frequency

of price changes is inactive and does not react to economic conditions. Instead, the results are in line with the predictions of the menu-cost model of Dotsey et al. (1999) that the frequency of price adjustment does respond to monetary shocks and that it varies with the business cycle. Moreover, similar results are found by Karadi and Reiff (2011) calibrating the state-dependent model of Midrigan (2011) accounting for larger shock sizes.

Figure 1.10: Impulse Responses to a Supply Shock

Notes: The black lines denote the median of the impulse responses following a positive supply shock, the red dotted lines indicate the “close-to-median” model, and the shaded areas indicate the 16% and 84% percentiles of the posterior distribution of the responses. Impulse responses are identified from a BVAR (1000 draws) using sign restrictions with a restriction horizon of 12 months. The impulse responses of industrial

production, the PPI and the Euribor are changes in (log) levels of the variables, impulse responses of the IM and EM are cumulative responses.

At this point, however, it is worth addressing a seemingly surprising feature of the results presented. The empirical results from the SVAR reported above suggest that the frequency of price changes is responsive to monetary shocks as well as aggregate demand disturbances. Since this evidence is obtained for the period 1991 - 2009, a period of relatively low and not so volatile inflation, these findings are somewhat surprising given the descriptive evidence offered in Section 1.3 suggesting that the EM is important for inflation dynamics mainly during high-inflation periods prior to 1990. However, these different findings can be reconciled by noting that while the evidence offered in Section 1.3 is concerned

with the overall comovement of the frequency of price adjustment with inflation, the SVAR analysis given in the second part of the paper specifically focuses on the dynamics of the EM conditional on specific shocks to the economy. Thus, it might well be the case that while the extensive margin reacts to a contractionary monetary shock or an aggregate demand disturbance during this low-inflation episode, it still is rather unimportant for overall inflation dynamics relative to periods of higher inflation.