Markup Pricing and Monetary Policy: A Reexamination of the Effectiveness of Monetary Policy under Imperfect Competition

Abstract

If markup ratios fluctuate widely, so does output volume and investment. This magnifies the business cycle and increases uncertainty about future economic conditions. This paper investigates the implication for monetary policy by analyzing markup ratios. The main conclusions are (1) as a result of the failure of Japanese firms to fully adjust their prices to exogenous shocks, markup ratios sometimes greatly deviate from trend lines. (2) According to the menu-cost theorem, the existence of costs associated with price changes prevents firms from changing prices to the level consistent with marginal costs, thus reducing social welfare. In this regard, establishing a money supply rule under which monetary authorities accommodate exogenous shocks provides an incentive for firms to change their prices. (3) Markup pricing magnifies the social welfare cost of inflation. In this argument, monetary authorities have the optimal choice of tightening monetary policy even under low inflation, if they observe that markup ratios have remained high.