Basic Calvo and P-Bar Models of Price Adjustment: A Comparison

It is clear that at present various versions of the Calvo (1983) model of price adjustment are dominant in monetary policy analysis—see, e.g., Woodford (2003). This is true despite well-known criticisms including Mankiw (2001) or Mankiw and Reis (2002) and the well-documented need for the addition of ad-hoc features if actual inflation and output data are to be matched. Accordingly, there is ample reason, to give consideration to alternative models. In this paper, a new look is given to the P-bar model utilized by McCallum and Nelson (1999a, 1999b), based on previous work by Mussa (1981) and others. Relative to the Calvo model, the P-bar specification has three significant advantages: it satisfies the strict version of the natural rate hypothesis; it relies on costs of adjusting output, which are more tangible than menu costs of changing prices; and its basic version produces more realistic autocorrelation patterns than does the basic Calvo specification. The present paper develops these comparisons more completely and systematically than in previous work.