Asymmetric Price Adjustment: Micro-foundations and Macroeconomic Implications

Abstract

We present a simple menu cost model which explains the finding that firms are more likely to adjust prices upward than downward. Asymmetric adjustment to shocks arises naturally, even without trend inflation, from the desire of firms to keep industry prices as high as is sustainable and the non-convexity due to menu costs. It implies that aggregate demand shocks have asymmetric effects - negative shocks are reduce output, whereas positive shocks are inflationary. We examine the implications of asymmetric adjustment for equilibrium output and the optimal inflation rate.