Monetary Policy obeying the Taylor Principle Turns Prices into Strategic Substitutes

Camille Cornand (1) , Frank Heinemann (2)

1 GATE Lyon Saint-Étienne - Groupe d'Analyse et de Théorie Economique Lyon - Saint-Etienne
2 TU - Technical University of Berlin / Technische Universität Berlin

Monetary policy affects the degree of strategic complementarity in firms' pricing decisions if it responds to the aggregate price level. In normal times, when monopolistic competitive firms increase their prices, the central bank raises interest rates, which lowers consumption demand and creates an incentive for firms to reduce their prices. Thereby, monetary policy reduces the degree of strategic complementarities among firms' pricing decisions and even turns prices into strategic substitutes if the effect of interest rates on demand is sufficiently strong. We show that this condition holds when monetary policy follows the Taylor principle. By contrast, in a liquidity trap where monetary policy is restricted by the zero lower bound, pricing decisions are strategic complements. Our main contribution consists in relating the determinacy and stability of equilibria to strategic substitutability in prices. We discuss the consequences for dynamic adjustment processes and some policy implications. Abstract Monetary policy affects the degree of strategic complementarity in firms' pricing decisions if it responds to the aggregate price level. In normal times, when monopolis-tic competitive firms increase their prices, the central bank raises interest rates, which lowers consumption demand and creates an incentive for firms to reduce their prices. Thereby, monetary policy reduces the degree of strategic complementarities among firms' pricing decisions and even turns prices into strategic substitutes if the effect of interest rates on demand is sufficiently strong. We show that this condition holds when monetary policy follows the Taylor principle. By contrast, in a liquidity trap where monetary policy is restricted by the zero lower bound, pricing decisions are strategic complements. Our main contribution consists in relating the determinacy and stability of equilibria to strategic substitutability in prices. We discuss the consequences for dynamic adjustment processes and some policy implications.

Mots clés: monopolistic competition; strategic complementarity; pricing decisions; monetary policy rule; strategic substitutability

Domaines: Economies et finances

Camille Cornand, Frank Heinemann. Monetary Policy obeying the Taylor Principle Turns Prices into Strategic Substitutes. 2018. ⟨halshs-01759692⟩