| Abstract: |
A number of recent papers point to the importance of distinguishing between
the price reaction to micro and macro shocks in order to reconcile the
volatility of individual prices with the observed persistence of aggregate
inflation. We emphasize instead the importance of distinguishing between
global and local shocks. We exploit a panel of 276 micro price levels
collected on a semi-annual frequency from 1990 to 2010 across 88 cities in 59
countries around the world, that enables us to distinguish between different
types (local and global) of micro and macro shocks. We find that global shocks
have more persistent effects on prices as compared to local ones e.g. prices
respond faster to local macro shocks than to global micro ones, implying that
the relatively slow response of prices to macro shocks documented in recent
studies comes from global rather than local sources. Global macro shocks have
the most persistent effect on prices, with the majority of goods and locations
sharing a single source of trend over time stemming from these shocks.
Finally, both local macro and local micro shocks are associated with
relatively fast price convergence. How fast do prices adjust to changes in
economic conditions? The answer is crucial in assessing the real effects of
nominal shocks, for instance. The literature provides conflicting answers:
whereas aggregate price indices have been found to be very persistent, more
recent work starting with Bils and Klenow (2004) showed that individual prices
adjust frequently. The implication that monetary policy might as a result be
less effective than previously thought, has been challenged more recently.
Boivin et al. (2009) attempt to resolve the micro-macro puzzle while retaining
the importance of monetary policy by distinguishing between the (sluggish)
response of individual prices to macroeconomic shocks common to every sector
or product, and their (rapid) response to microeconomic shocks specific to a
sector or product. Our paper emphasizes the distinction between global shocks
common to every location worldwide, and local shocks specific to a location.
We show that this distinction is much more striking and no less informative
for price-setting models, than the macro-micro split considered in previous
work. In fact, we find that the speed of price adjustment in response to local
macro shocks or local micro shocks is relatively fast in both cases. At the
same time, the price persistence associated with global versus local shocks of
any type differs substantially. For both macro and micro shocks alike, local
components are associated with much less persistence than global ones.
Considering only one type of micro or macro shock would consequently hide the
heterogeneity we observe in their effects and lead to misleading inferences
about the relative persistence of local macro shocks (typically monetary ones)
in micro prices. Based on our findings, price-setting theory models should not
include as high a degree of price rigidity in response to local macro shocks
as that implied in some of the earlier empirical work. At the same time, our
work suggests the need for open economy price-setting theory models consistent
with slow response of prices to global micro shocks and persistent price
effects of international macro shocks. Our analysis relies on a panel of 276
micro price levels collected from 1990 to 2010 at a semi-annual frequency
across 88 cities in 59 countries across the world. This dataset is
non-standard and was especially compiled for us by the Economist Intelligence
Unit (EIU) at a semiannual frequency for the complete untypically large sample
of international locations. The March and September dates for gathering these
semi-annual data are specifically designed to avoid standard sales seasons. In
addition, EIU correspondents are specifically instructed to take regular
retail prices and not to take sale prices. These sampling facts suggest that
our price data are not as prone to include temporary price changes, shown by
Nakamura and Steinsson (2008) to bias results towards finding more rapid price
adjustment. This is important for the inferences we can draw about the speed
of price adjustment in response to local shocks for instance. The three
dimensions of our panel---time, location and individual product---allow us to
decompose the dynamics of the common currency micro price-level for each
product in a given location at a given date into four different components:
(1) a global macro component common to every good in every location, capturing
for example global oil shocks; (2) a global micro component specific to a good
and common to every location, related for instance to technology shocks
specific to a product but common across the globe; (3) a local macro component
specific to a location and common to every good, related for example to
monetary policy; and (4) a local micro or idiosyncratic component specific to
a good and a location, capturing for instance the idiosyncrasy of weather
conditions facing vineyards in a certain location. We obtain convergence rates
specific to each component allowing for different speeds of price adjustment
to these, our notion of price adjustment speed being the time it takes for
prices to fully adjust to a shock. While ignoring the global-local distinction
our data would imply that (similar to past research on the micro-macro gap)
macro shocks are more persistent than micro ones with convergence rate
estimates implying half-lives of 21 months versus 13 months respectively,
decomposing macro and micro shocks into their global and local components
reveals a different more precise picture. Local micro shocks are the most
rapidly corrected ones, followed by local macro shocks, and global micro
shocks. More precisely, local micro shocks have a half-life estimate of about
7 months. The reaction to local macro shocks is somewhat more persistent with
a half-life of 10 months, while global micro shocks have a half-life that is
about twice as long at 18 months. The latter three components of international
prices are mean-reverting on average, but this does not apply to all relative
prices for all goods or locations. The response of prices to global macro
shocks is found to be permanent so that international prices share this single
global stochastic trend which is the main factor behind the observed drift in
price levels. Furthermore, we find that the global macro and micro components
together account for half of the time-series volatility in prices in this
sample. The above findings taken together suggest that global shocks cannot be
ignored when analyzing the sources of persistence and volatility of prices.
Our results confirm that prices react differently to different types of
shocks, but stress that sorting shocks by geographic distance (global vs
local) leads to more striking differences than sorting shocks by mere economic
distance (macro vs micro). The observed differences in persistence of the
different price components could stem from differences in the persistence of
the shocks driving the processes associated with these components rather than
from differences in the reaction of prices to these shocks. We thus
investigate further by considering the link between persistence and volatility
of the price components. If persistence of the shocks themselves was the main
driver of the observed persistence in prices, then we would expect to see a
positive relation between own persistence and volatility. The estimated link
between these turns out to be either negative or statistically
indistinguishable to zero. This leads us to infer that price adjustment to
different types of conditions does not stem from the mere persistence of the
shocks. The link between persistence and volatility provides us with a couple
of additional new facts. First, more volatility in micro conditions is
associated with slower adjustment of prices, hence more persistent relative
price distortions, in response to changes in macro conditions. Likewise, more
volatility in local conditions is associated with slower price adjustment,
hence more persistent relative price distortions, in response to changes in
global conditions, with this link more than twice as large as the respective
micro-macro link. We propose that decomposing macro and micro shocks into
finer categories provides a new more precise tool for gauging models of
price-setting. The persistence associated with each of these components and
its relation with volatility of the different components, provide new facts
that price-setting models should be able to rationalize. First, in light of
the importance of the global or international dimension, it would be useful to
have open economy price-setting models that can rationalize differences in the
speed of adjustment to global versus local shocks in addition to macro versus
micro shocks. These models should be able to explain why these differences are
more striking when shocks are classified with respect to geographic distance
(global vs local) rather than mere economic distance (macro vs micro). Second,
models of price-setting should be able to cope with the estimated sign and
size of the link between local volatility and the rate of price adjustment in
response to global shocks. Again, they should also be able to explain why the
volatility in local conditions seems to be more detrimental to the adjustment
to global conditions, as compared to the effect of volatility in micro
conditions for the adjustment to macro conditions. One possibility would be to
resort to models of endogenous imperfect perception of shocks, in the spirit
of the recent contributions of Reis (2006), MaÃÂkowiak and Wiederholt
(2009), Woodford (2009) or Alvarez et al. (forthcoming), where the relative
cost of observing global conditions would be greater than the one associated
with monitoring local ones, and more so than the relative cost of observing
macro conditions exceeds that for micro ones. Similarly, in the context of
these models, the loss of processing capacities due to volatility in local
conditions could be more detrimental to the monitoring of global conditions,
as compared to the loss of processing capacities due to volatility in micro
conditions for the monitoring of macro conditions. Rational inattention models
are thus a natural candidate to consider for understanding our results. Yet
another theoretical possibility would be to rely on labor market segmentation
arguments, in the spirit of Carvalho and Lee (2010). Here, the segmentation
would need to be greater between countries than within them in the same manner
(but more so) that labor segmentation is greater across sectors than within
them. However, this framework would also need to incorporate a link between
volatility of shocks and persistence of price reactions. Our results on the
differential response of prices to different types of shocks extend Clark
(2006), Boivin et al. (2009), and MaÃÂkowiak et al. (2009), to a global
environment. These papers bridge the gap between measured persistence of macro
price indices and the frequent adjustment observed in micro prices. In their
setup, a macro shock is common to every sector in the US, potentially
encompassing a shock common to every country worldwide (our global macro
shock) and a shock specific to the US (our local macro shock). Likewise, their
sectoral shock can be made of a worldwide sectoral shock (our global micro
shock) and a US sector-specific one (our local micro shock). Our work points
to the importance of disentangling global and local components to understand
price dynamics. No study of micro price levels has looked at this global/local
decomposition of micro and macro shocks. We show that whereas global macro
shocks are highly persistent, prices react to local macro shocks much faster
than to global micro ones. By contrast, Boivin et al. (2009) find that
sectoral prices adjust sluggishly to macro shocks but rapidly to micro ones, a
result that has in turn spurred a debate on what theoretical model of
price-setting could rationalize such different response of individual prices
to different types of shocks. In their own words, their "main finding is that
disaggregated prices appear sticky in response to macroeconomic and monetary
disturbances, but flexible in response to sector-specific shocks" and that
"many prices fluctuate considerably in response to sector-specific shocks, but
they respond only sluggishly to aggregate macroeconomic shocks such as
monetary policy shocks". To the extent that country-specific monetary policy
is part of our local macro component, we find that it has much less persistent
effects than in Boivin et al. (2009). Prices respond almost twice as fast to
local macro shocks as they do to global micro ones. This also contrasts with
the finding of a rapid adjustment to micro shocks in Boivin et al. (2009). The
subset of our results that pertains to local micro and local macro shocks
contributes to yet another line of research; the literature on international
price comparisons. Until recently, international price differences were
considered to be very persistent at the aggregate level. Deviations from PPP
have a half-life of several years as documented in the surveys by Rogoff
(1996) and Obstfeld and Rogoff (2000). The survey by Goldberg and Knetter
(1997) stresses that the persistence is of comparable order when one considers
deviations from the LOP using relatively aggregated sectoral price indices.
Instead, the recent evidence relying on micro-data, such as Goldberg and
Verboven (2005) using European car prices, Crucini and Shintani (2008) using
annual EIU prices, and Broda and Weinstein (2008) or Burstein and Jaimovich
(2009) using barcode prices, is that the persistence of LOP deviations is
reduced sharply when based on micro prices with higher comparability across
locations. Our estimated half-lives are even lower than in the recent
micro-price literature on LOP deviations, in part due to the use of semiannual
prices and a broader sample of locations across the world as compared to the
previous studies. Although the scope of our paper is broader, to the extent
that a subset of our results relates to the LOP literature discussed above
they are also relevant for the Bergin et al. (2011) argument that the
differential importance and persistence of (local) macro versus (local) micro
shocks for LOP deviations can reconcile the macro with the micro evidence for
international price convergence rates estimates. They show that macro shocks
that dominate at the aggregate level are less volatile and have much greater
persistence than idiosyncratic shocks at the individual good level that
dominate micro prices. We estimate a more persistent response of individual
prices to local macro shocks than to idiosyncratic ones in most cases.
However, both responses are relatively fast and not always that different
except for developed countries. Thus, our results suggest that the micro/macro
gap between fast convergence in deviations from the LOP (micro) and the very
persistent deviations from PPP (macro) cannot be entirely resolved by
distinguishing between (local) macro and (local) micro shocks in the LOP as
there is typically not that much more persistence in local macro shocks as
compared to local micro ones. Apart from the much more general sample across
(developed and developing) countries and goods (traded and non-traded), and
the longer time span being considered in our paper, one factor driving
differences in estimates for the local micro and local macro components in the
two papers, is that Bergin et al. (2011) use the US as the comparison point
relative to which to construct LOP deviations. Choosing a particular location
as the comparison point introduces the statistical properties characterizing
it into the deviations from the LOP for every other location. Instead, we
choose to compare prices to the average across locations so that our findings
do not depend on choosing a particular country as the comparison point.
Finally, our findings do not depend on using the US dollar as the numeraire
currency. Converting prices to the same currency is necessary for comparison. |